Weekly Update
The market hates uncertainty and it is getting it by the bucket-full right now. If you need a simple explanation for this volatility, that’s it.
If you’re looking for specifics as to why certain stocks are correcting by so much and others aren’t, you’re likely to come up short. That’s just the nature of the market at times like this and why it can be so challenging to hold good stocks through market downturns.
Look at the big picture as a prime example of uncertainty. Up until the September 26 FOMC statement the Fed had prepped the market for a federal funds rate that shouldn’t exceed 3.0% by the end of 2019. The monetary stance was “accommodative.”
Minutes from the September meeting then showed the word “restrictive” was used for the first time since the economic expansion began. Interpretation: the federal funds rate could go as high as 3.25% to 3.5% in 2020, well above what was previously expected.
Theoretically, such a move would be aimed at keeping a lid on inflationary pressures and to stop the economy from overheating. Is it possible that the Fed sees Trump’s tax cuts as driving excess and feels the need to keep growth in check before it goes too far too fast? Is that why Trump has had choice words for Fed Chair Jerome Powell?
There are certainly other factors at play that are driving the market, but this is one of the big ones, if not the biggest. And as observable interest rates go up, along with projections for future increases, stock prices come down.
Why now, and not before? Because a federal funds rate above the 3.0% “neutral” level moves it from “accommodative” to “restrictive.”
A perfect example of how that affects stocks is found in the mechanics of how analysts compute stock price targets. Part of the equation is based on the discount rate, which is directly affected by interest rates. I won’t get into the details, but earlier this week I crunched the numbers on 10 software stocks covered by Morgan Stanley and found the average price target cut was 5%, just because of the recent jump in interest rates (for the record, most of the revised price targets were still above where those stocks trade today).
The takeaway message is that the market dislikes uncertainty. And the pace of interest rate hikes, and the potential for further increases, is creating it.
In this environment anything else that plays into top-of-mind concerns (tariffs, slowing growth, margin contraction, etc.) only fuels the uncertainty.
Look at Amazon (AMZN) today. Revenue in Q3 was light (only missed by $540 million on revenue of $56.6 billion) but EPS beat by a mile ($5.75 beat by $2.66!). The stock is down.
Yesterday GrubHub (GRUB) beat on revenue and EPS, but guided light. Stock down.
Microsoft (MSFT) beats on both, guides fine. Stock strong.
LogMeIn (LOGM) goes into the print with low expectations, beats on both revenue and EPS and gives upside guidance. Stock up.
These reactions reflect the level of uncertainty in the respective stocks, and the market trying to bring imperfect information together to place a value on them. It’s a very imperfect art, especially when the variables are unknown and always changing.
The obvious question is: What does this mean for our small-cap stocks?
We’ve taken partial profits on all stocks that had significant gains and began to falter. We are now holding our remaining positions through earnings, which will help us figure out which will be leaders again when this correction is over. We’ll know that because we’ll have better information and less uncertainty.
We also have a number of newer positions that are still rated buy because they’re looking good despite the market environment. There is less uncertainty with these stocks and we added them closer to the current investing environment.
Stepping back to look at the market we see both the S&P 500 and S&P 600 Small Cap Index trading around break-even in 2018 after giving up all their gains in September and October. Common sense and the charts suggest both should be able to find support around this level. Given that both indexes now trade with forward P/Es in the 15s (where they haven’t been since early 2016), valuations are starting to look attractive.
That’s not to say it is time to start buying hand over fist. The big money isn’t made trading around earnings reports (tempting though it can be), but in the long-term moves that great stocks make.
Our job is to try and listen to the market, average in and out, and stay disciplined enough to keep some skin in the game during corrections so we’re positioned for the select few outliers that drive big gains after.
Keep averaging in to the stocks I have rated buy. If you’re brave, feel free to nibble on a few shares of those stocks we’ve taken partial gains on and that are going into earnings next week with a hold rating. One thing I know for sure is that there will be big moves in some of these stocks after earnings. I just don’t know which ones will deliver the big gains. The lower-risk play is to sit on our hands now, then figure out our next move afterward.
Finally, I’m working on next week’s Issue, which features a stock that’s held up great in October. It’s benefiting from a secular growth trend that we don’t have any exposure to yet. And I think it’s just the ticket for this environment.
Changes this week:
IntriCon (IIN): Sold a quarter, hold the rest
Updates
Altair Engineering (ALTR) is a simulation software stock that helps companies design new products, use new materials, cut waste and get products to market faster. The stock is off its 52-week high by roughly the same amount as the S&P 600 Small Cap Index (about 15%), above its 200-day line, and above a zone of support in the 33-35 price range. The message is the same as last week; Altair’s risk vs. reward profile looks attractive here so keeping at Buy. This week the company announced it’s expanding its relationship with Oracle to offer a new flow simulation solution (Computational Fluid Dynamics, or CFD) on Oracle Cloud Infrastructure. Offering these solutions in the cloud means Altair’s customers can access GPU-based solvers on-demand, without having to purchase, maintain and upgrade their own hardware. BUY.
Earnings Release Date: November 8
AppFolio (APPF) will report on Monday and with the stock trading around its 200-day line, a valuation below its prior peak (EV/2019 Revenue ratio at 8.3 now versus previous high of 9.1 in 2017) and fundamentals much improved (2018 and 2019 expected EPS of $0.76 and $1.11, respectively, versus $0.45 in 2017) it would seem a good time to start nibbling on shares. The counter-argument is that the stock has been in decline for a month so clearly the trend is not strong. We’ll wait until after earnings to decide on our next move. HOLD 1/2.
Earnings Release Date: October 29
Apptio (APTI) will also report on Monday and with revenue expected to accelerate to over 20% in 2018 and for profits to turn positive (expected EPS is $0.05) I’m expecting a positive reaction. That said, we’ll need to see evidence that the Global 10,000—companies with IT budgets under $100 million—are continuing to sign up. This is where future growth is likely to come from (along with broadening customer use cases) so management commentary on the trends is important. Interesting news this week: Apptio is teaming up with Coupa to integrate its industry-standard IT cost model into Coupa’s Business Spend Management Platform. When Coupa customers enter their purchase orders on the platform Apptio’s technology will automatically categorize them, and that data will go into Apptio’s analytics engine, which gives customers visibility on technology spend (among other things). The partnership could also help drive Coupa’s customers to adopt Apptio’s software. It’s an interesting partnership and it doesn’t require a lot of creativity to see a future where these two companies get even closer. For the very risk-tolerant picking up a few shares of Apptio here could pay off. But without a big enough sample size of software companies having reported it’s just too hard to gauge how Apptio will react to earnings, even if they’re positive. HOLD 1/2.
Earnings Release Date: October 29
Arena Pharmaceuticals (ARNA) has been all over the map this week on no new news. The stock sold off on Wednesday and found support at the August low, before clawing back some of the decline yesterday. It’s down 3% from our entry point and is still a long-term Buy. Average in. BUY.
Expected Earnings Release Date: Second week in November
AxoGen (AXGN) is finally about to face its day of reckoning on Monday. We’ve been waiting since the last quarterly report to see if we can take management at its word that the company is still on pace to achieve 40%-plus growth this year (and in 2019 too). The speculator in me wants to move to buy here, and if you’re a gambler you can grab a few shares. But this environment is just too uncertain for most investors to take big risks. Expect significant movement in AxoGen after the report, after which I’ll update my rating. For now, it’s a Hold. HOLD 1/2.
Earnings Release Date: October 29
Bottomline Technologies (EPAY) hasn’t been immune to the volatility but its action—up 5% last week, down 3% this week, 13.5% off 52-week high and barely below its 50-day line—continues to suggest bigger investors have confidence in what management is doing. Keeping at Buy, just keep new positions small. BUY.
Expected Earnings Release Date: First week in November
Chefs’ Warehouse (CHEF) was moved back to buy last week and has responded by tightening up its trading range right around the 50-day moving average line. It was up a fraction this week and I’m keeping at buy. As I said last week I think the rough upside/downside in the near-term is around 20%-12%. The underlying trend behind the company’s growth is consumers dining out at independent restaurants. And Chefs’ is on the tail end of an investment phase that should drive rapid EPS growth (77% this year) and more modest revenue growth (10.2% this year). The company will report next Thursday. Remember that Chefs’ was just added to the S&P 600 Small Cap Index. Keeping at Buy. BUY.
Earnings Release Date: November 1
Everbridge (EVBG) is doing its job as well as we can expect. The stock is well off its 52-week high but has risen off its early-October low near 45, which was fractionally higher than the dips in June and July. Revenue growth is expected to be 38% this year and 26% in 2019. Earnings are out a week from Monday. HOLD 1/4.
Earnings Release Date: November 5
Goosehead Insurance (GSHD) has had a terrific week, rising by 19%. As I wrote in Wednesday’s Special Bulletin the catalyst is the IPO lockup expiration, which has increased the number of shares that can trade freely. Based on the reception, I’d say demand is high. Volume has picked up over the last three sessions. Don’t go in hard here since a dip is easily possible. But keep averaging in, preferably a little lower, to build up to your desired position size. BUY.
Instructure (INST) was sold two weeks ago to protect us from a loss. It’s now on the watch list for future inclusion if the trend improves. Watch for earnings on Monday to be a significant event. SOLD.
Earnings Release Date: October 29
IntriCon (IIN) will report a week from Monday. We were forced to sell a quarter position earlier this week (I sent out a Special Bulletin) since the stock keeps inching down. I expect the upcoming earnings release will help the stock firm up. IntriCon is well positioned to benefit from expanded manufacturing capacity and robotic assembly of continuous glucose monitors (CGMs) for Medtronic (MDT), and to pursue opportunities with other potential clients it hasn’t had capacity for. Then there’s the hearing aid optionality in the stock. It’s too early to know if IntriCon will be able to grab a good chunk of the market for the emerging OTC hearing aid category. But if it can, and its direct-to-consumer website takes off, the results could be huge. As with most stocks that have been falling and that we took partial profits on, IntriCon is a Hold now. We’ll reevaluate once the earnings report is in the books. HOLD 3/4.
Earnings Release Date: November 5
Q2 Holdings (QTWO) is settling in around the 50 level and is unchanged for the week. No fundamental updates. The company will report a week from Tuesday. I like the stock, just not the trend. HOLD 1/4.
Earnings Release Date: November 6
Rapid7 (RPD) is also hanging in there and was largely immune to the market’s broad swings this week. Directionally, it traded in-line, but it never moved out of the 32 to 34 trading range. The stock is unchanged for the week. We’ll get the earnings report a week from Tuesday. This is a stock that the chart says we can buy now but I want to hear what the trend in new customer bookings looks like before we move off the hold list. HOLD.
Earnings Release Date: November 6
