The big news this week is that we: (1) recovered some of last week’s losses and (2) have a notable acquisition in the small cap cloud software space.
First, we enjoyed a little bounce in the portfolio even though small caps were down 1.8% yesterday. Since last Thursday’s close our portfolio is up 4%. Only two stocks, IntriCon (IIN) and Goosehead Insurance (GSHD), were down, and those 1% retreats don’t mean much in the grand scheme of things. Decent upside moves were seen in Everbridge (EVBG), up 11%, AxoGen (AXGN), up 9%, Altair Engineering (ALTR), up 7%, Chefs’ Warehouse (CHEF), up 6%, and Bottomline (EPAY), up 5%. I expect we’ll see stocks move up and down over the coming weeks as the market digests the dramatic decline from early-October.
On the acquisition front we saw a mid-cap software company throw down for a small cap company that’s only been publicly traded for about a year. Communications software specialist Twilio (TWLO) snapped up SendGrid (SEND) to fill the one big gap (email) in its communications solutions lineup. The price—around $2 billion—implies an enterprise-value-to-2019 revenue multiple (EV/2019 revenue) of about 11-times for SendGrid. That’s not a target valuation for all small cap software stocks, but it does suggest that demand still exists for the right asset, even at a relatively high multiple. For reference, SendGrid is on track to grow 2018 revenue by around 29% and is profitable; expected EPS for 2018 is $0.16. That profile is fairly similar to several of our small cap software stocks.
Back to the broad market, my current working hypothesis (which I reserve the right to change) is that this is a normal correction in the context of an ongoing, albeit old, bull market.
Looking through the data it’s now clear that small caps and software stocks were the last major asset classes to succumb to downward pressure. Now that they have, we may see the market begin to firm up and start to show signs of new leaders. That’s the glass-half-full perspective.
Alternatively, rising interest rates, trade wars, missing journalists and any number of other issues that haven’t tripped up the market in a major way yet could represent the breaking point and send us lower. We’ll just have to keep our eyes open and ears to the ground.
In terms of small cap stocks, if you look at the S&P 600 you see it’s down around 12% from its late-August high (reference the dark green lines in chart below). That’s about the same as the retreat around this same time of year in 2014. And not quite as bad as the mini-bear market in late-2015 and early-2016 (small caps fell more than 20%). To put things in context, a decline of around 19% from the September peak would bring small caps back to where they were in late-2017 and early-2018 (blue line in chart below).
The last thing I’ll say about the small cap asset class is that, as the bright green lines in the chart above show, small caps were up almost 50% in less than two years before this pullback! When you think about that, it’s a lot easier to remain calm about a 12% decline, even one as rapid as this one.
I won’t spell out everything in the chart below since it more-or-less speaks for itself. What we’re looking at here are the last three significant declines in the iShares North American Technology Software ETF (IGV). This ETF is a decent proxy for software stocks (65 stocks across market caps). The idea here is just to help put a little context around what’s going on now.
Moving on to our portfolio, our two newest additions, Altair Engineering and Goosehead Insurance, are down in-line with the small cap asset class at -12% and -10%, respectively, since we added them. That’s not great, but it’s not abnormal, either. An average gain of 11% on our six most recent additions has me feeling OK about our ability to avoid any real tragedies (at least thus far).
That’s not to say it is time to take a victory lap. We’ll leave that to the Red Sox who move on to the World Series next week!
But while we’ve taken one step back we are still sitting on an average gain of 58% on currently open positions, only have two that are in the red (with reasonable losses), have booked an average gain of 56% on positions (full and partial) closed in 2018 and an average gain of 87% on positions (full and partial) closed since the beginning of June.
Another bright spot is that this correction is helping me better distinguish stocks that should be leaders moving forward. And my list of candidates for the November Issue is down to just two. Both look great!
Changes this week:
Chefs’ Warehouse (CHEF) moved to Buy
Updates
Altair Engineering (ALTR) is a simulation software stock (computer aided engineering, to be specific) that helps companies design new products, use new materials, cut waste and get products to market faster. The company is all about transforming design and decision making throughout product lifecycles by applying simulation, machine learning and optimization. The software is used in markets where physics really matter—think aerospace, heavy equipment and automotive industries. It’s also used in sporting goods and medical device markets. Customers include Ping Golf, Medtronic and Daimler. I added the stock to the portfolio a couple weeks ago, which didn’t work out particularly well as far as my reference price is concerned. But hopefully you’ve been able to take advantage of the selloff to establish a position at a better price. I mentioned in my report that we could see the stock get down into the 34 to 35 range “if the market weakened”, which is exactly what happened. It’s a Buy here. Yes, it could go lower, but the risk vs. reward profile at this price is worth building a position. BUY.
AppFolio (APPF) has given us an earnings release date of a week from Monday. AppFolio is still trading at an elevated valuation; the EV/2019 Revenue ratio is 9.5, which is the peak valuation from 2017 (this metric got as high as 13 in September). That’s not a completely insane valuation (Shopify (SHOP) trades at a similar multiple), but it’s still high enough to say AppFolio is a Hold here, even with 2018 expected revenue and EPS growth of 28% and 69%, respectively. HOLD A HALF.
Earnings Release Date: October 29
Apptio (APTI) is a stock that we were forced to take partial gains on but which I’m watching closely since I’d like to put it back on the buy list. I think the long-term potential here is huge and once investors come back to cloud software names, Apptio will be on the buy list. Technically speaking, the stock’s not a buy yet. It fell below the 200-day line last week and has been searching for direction over the last week with no net progress. Revenue growth should be north of 20% this year and I won’t be surprised if 2019 could deliver similar growth (current consensus is 17%), but shares might not get the benefit of the doubt until management gives guidance. Another positive here is that Apptio should turn profitable this year (expected EPS is $0.05) then grow EPS by around 360% (to $0.23) in 2019. In terms of valuation, the EV/2019 Revenue multiple of 4.6 is well off the September high of 6.4 and back to where it was in late spring. Earnings will be out a week from Monday. If we get some positive signs from the market, we might be able to put it on the buy list for risk-tolerant investors ahead of earnings. HOLD A HALF.
Earnings Release Date: October 29
Arena Pharmaceuticals (ARNA) was up 2% this week on no new news. It’s still a long-term Buy. BUY.
Expected Earnings Release Date: Second week in November
AxoGen (AXGN) walked up 9% this week and is back to where it was in mid-September. The deal here is that shares can’t figure out the next move until management reports and we know for sure that the company is on track to achieve 40% plus growth this year and, hopefully, in 2019 too. If we get that with no big surprises, the stock should enjoy at least a decent rally. If we learn that the tweaked/expanded sales force is really churning out sales, then the move could be bigger. On the other hand, any confirmation of the market’s concerns regarding the sales force are valid could cause the stock to suffer another leg down. Risk tolerant investors can trade around earnings, and if you don’t own any shares you could take a small position here. I expect to hold our remaining position through the earnings report and then, based of the results and the stock’s reaction, decide what to do next. We’ll know a week from Monday when earnings come out. HOLD A HALF.
Earnings Release Date: October 29
Bottomline Technologies’ (EPAY) resilience is showing that bigger investors have confidence in the moves management has made and that the financial technology company has a bright future and growth should accelerate. We’re looking for revenue growth of 8.5% this year and 10.5% in 2019, and EPS growth of 14.2% and 16.6%, respectively. Same as last week—I’m keeping at Buy, just keep new positions small. BUY.
Expected Earnings Release Date: First week in November
Chefs’ Warehouse (CHEF) rallied to a 52-week high two weeks ago after it was added to the S&P 600 Small Cap Index, but around two-thirds of that quick gain evaporated last week. Shares fell just below their 50-day line but have clawed back up to that technical level this week. This is a stock I think you can buy here if you’re looking for something that’s not likely to go to the moon overnight, but also has very solid support 10% to 15% below where it is now. Roughly, I’d say the upside/downside potential is around 20%/-12% over the next month. And I like those odds. We might be a little early, but I’m moving Chefs’ back to Buy here.
Earnings will be out two weeks from yesterday. The market is looking for 10.2% revenue growth and 77% EPS growth, to $0.78, this year. BUY.
Earnings Release Date: November 1
Everbridge (EVBG) found support at 45 last week, which marks the third time the stock has held at slightly higher prices since it broke above 42.5 back in May. The chart is saying this is a stock that investors want to hold on to (it’s 18.5% off its 52-week high but solidly within the mid-summer trading range of 43 to 53) and valuation seems reasonable to me (EV/2019 Revenue ratio is 8.4, which is just above where it was in July). The company announced it recently received a Provisional Authorization (PA) for Impact Level 2 from the U.S. Department of Defense (DoD), which authorizes all DoD missions and agencies to leverage the Everbridge Suite of solutions to safeguard military personnel, civilians, and contractors, as well as defense facilities and assets, at home and abroad. This is another example of the potential of Everbridge’s software to gain widespread use around the world. Revenue growth is expected to be 38% this year (26% in 2019) and the company only has a market cap of $1.5 billion. Continue to hold your shares. HOLD A FOURTH.
Earnings Release Date: November 5
Goosehead Insurance (GSHD) is trading slightly above what should be an area of rock-solid support around 24. We’re down from our entry price in early-September, but that’s not a huge concern in my mind. This stock is relatively new to the market and it’s not a well-known story, yet. That will change. We’re looking for 40% revenue growth this year, accelerating to around 45% in 2019, with EPS of around $0.25 in 2018 rising by 75% to $0.44 next year! I can’t guarantee that this scenario will play out but I can say with conviction that if it does the stock should be higher than it is now. The business has momentum and should be a cash-generating machine. Given there’s not a pipeline of acquisition targets out there (its business model almost necessitates organic growth) Goosehead could easily initiate a dividend at some point. It’s a Buy. BUY.
Instructure (INST) was cut loose last week after shares fell below 32. It’s now on the watch list for future inclusion if the trend improves. Watch for earnings a week from Monday to be a significant event. SOLD.
Earnings Release Date: October 29
IntriCon (IIN) has been open in a chart on my computer all week and it’s been hard to hold off on the “sell half” button given that the stock dipped below the 50 level I suggested as a mental stop early in the week. I’ve held off on taking partial gains because it feels like the market has been firming up and IntriCon has been trading in a relatively tight range. We also had some incrementally positive news on the OTC hearing aid market (Bose Hearing Aid approval) and shares of Medtronic (MDT), IntriCon’s biggest customer, have been rock solid. None of this means IntriCon will blast off tomorrow, but when you’re looking for potentially positive news in a sketchy market it’s not hard to make a compelling list. Keep Holding. We have an earnings date that’s two weeks from Monday. HOLD.
Earnings Release Date: November 5
Q2 Holdings (QTWO) broke out from the 50 level in early-May after reporting Q2 earnings and after this recent correction the stock has fallen back to around that same level. There’s no sugarcoating it—this is a significant correction for the stock (22.5% from 52-week high). On the other hand, it’s a high-quality name that should draw buyers once appetite for software stocks returns. This week management announced that it’s closed the previously-announced acquisition of Cloud Lending, which brings a broader portfolio of digital banking solutions in areas such as deposits, lending, leasing, security and fraud. Hold on to your remaining position. Earnings are out on November 6. HOLD A FOURTH.
Earnings Release Date: November 6
Rapid7 (RPD) has held up as well as any software stock lately, which might be a reflection of the fact that it didn’t rise as much in August and September as many other names. Even though I’m not officially moving it to buy today, I’m OK if you want to nibble on the stock around here. This week management announced the acquisition of tCell.io, a small provider of web application threat defense and monitoring that has a few notable clients, including Veeva Systems, John Muir Health and Zenefits. HOLD.
Earnings Release Date: November 6
