Our six-year old son planned to be a Monarch butterfly for Halloween. Everything was set, the costume was on, and we were headed out to the early-evening party when he decided to run upstairs and look in the mirror.
That’s when the wheels came off. In his mind he expected to look like a real Monarch. The disappointment was overwhelming when he realized, “Dad, I just look like a little boy in weird pajamas.”
To make a long story short, there was no Halloween for that little guy, whose expectations were shattered in such a short a period of time that recovering and re-engaging in the festivities was just not going to happen.
Meanwhile, our almost three-year old, who was 100% the more ridiculous-looking one of the two, walked up and down the street wearing his beach ball costume. He never had huge expectations, therefore he lived in the moment and bounced around the street collecting just enough fruit and sweets to feel satisfied.
These two ways of dealing with what was essentially the same exact situation got me thinking about how investors dealt with the market volatility in October (which continues today in some areas).
I’m sure many wanted to climb under their beds and hide, just like my older son. Trying to block out the market when it gets overwhelming is a very strong emotional urge, and one that’s not easy to deal with.
That’s especially true when expectations were high, as they were groomed to be. Small-cap stocks rose 87% from the beginning of 2016 through September 2018. They were up almost 16% year-to-date before the market fell apart. Many individual stocks were up far more, including several in our portfolio.
The September-October slide pulled the S&P 600 Small Cap Index down to its February low and wiped out all the year’s hard-earned gains, and then some. Many small caps fell 20%, or more. Things are looking better now, but it’s a little early to wave the all-clear flag.
The problem with crawling under our beds during such a market is that doing so doesn’t alter reality. Checking out just means investors lose the opportunity to learn, potentially profit, cut losses short, take partial gains, etc.
To be clear, I’m not saying investors should watch with baited breath. If your natural tendency is to observe the market from afar while staying invested, that’s great. I’m referring more to the investor that starts to lose all control during market volatility and succumbs to emotional reactions that are likely to result in financial pain.
Investing in individual small-cap stocks means we are guaranteed to endure intense bouts of market volatility that will drive stocks up more than they should go up, and down more than they should go down. Our portfolio is designed to make money over the long haul. It’s not built around a short-term trading strategy. And we’re not investing in ultra-speculative companies that are equally likely to implode as they are to shoot higher.
These are legitimate businesses that are more likely than not to increase in value over months and years.
Given that, the best way to handle periods like October (and now) is to make incremental moves. Buy a little, sell a little. Average in, average out. Don’t make all-or-nothing decisions. Realize that what you do over the course of one day, one week or one month contributes to your average returns over the course of one, three, five or 10 years. Don’t be too focused on the day to day.
I’m not saying the short term doesn’t matter; obviously it does. I’m saying that things don’t always go as planned and to expect the unexpected. It’s better to roll through it with head up and eyes open, more like a bouncy beach ball, than under the bed like a distraught butterfly that just had his wings clipped.
As I’ve been observing the market a few things have started to crystalize in my mind.
First is that there have been huge moves in stocks that don’t make a lot of sense. There are plenty of examples of stocks that reported blowout quarters and jumped, and those that missed and gave weak forward guidance and fell.
But the degree of the moves in many stocks is not natural. IntriCon (IIN) is just one example. The stock fell over 20% the morning after it reported, only to come back to break-even before the session ended. Altair Engineering (ALTR) fell almost as much after announcing an acquisition. And today, Bottomline Technologies (EPAY) opened 20% lower when, in the words of one analyst, the only thing to pick at was some softness in bookings. But management was very clear that the current quarter is a seasonally slow one and, as always, business ramps up as the fiscal year progresses. In other words, the business is just fine.
These are just the examples from our portfolio! There are many, many more out there.
I’m not a trader so I’m not watching a Bloomberg terminal to try and figure out who’s buying and selling, what the short interest is and if a stock’s trading action is being driven by algorithms or humans. But you don’t have to be to know that this stuff is going on. It is, and, to my eye, the moves in many stocks seem detached from reality.
Today, Bottomline Technologies remains a BUY.
Second, the market is being manipulated by the Fed. That should come as no surprise because it’s nothing new and I’ve already written about it at some length. Just don’t lose sight of the relative importance of interest rate policy on equities. The market expects the Fed to raise the prime lending rate again in December. That’s hurting stocks—even if in the big picture it’s good to take steps to reduce the risk of bubbles emerging and stop the economy from getting overheated.
Third, the demand for technologies that we’ve been investing in, namely cloud software, medical devices, etc., isn’t going away because the stock market’s been volatile. Sure, demand will go up and down depending on how the economy does (it seems to be doing just fine) and that will affect revenue and EPS trends.
But the big change right now is just what the market is willing to pay for these stocks. Generally speaking, valuations got too high in August and September. October (and probably November too) represent a re-adjustment period.
Finally, I continue to think the market’s volatility is a relatively normal correction. Again, I reserve the right to change my view as new data and market events unfold. But for now, my plan is to keep making incremental moves to try to limit risk and pursue opportunities. Hopefully that will mean a number of positions move back to buy in November. But I’ll be waiting to see the trends improve before acting, with just one exception (noted below).
There are three earnings updates today including Arena Pharmaceuticals (ARNA), Altair Engineering (ALTR) and Bottomline Technologies (EPAY).
There is one rating change this week:
Altair Engineering (ALTR) moves back to BUY
Updates
Altair Engineering (ALTR) reported earnings Thursday night and revenue growth of 10.5% to $93.9 million missed by $1.6 million while adjusted EPS of $0.07 beat by a penny. The revenue miss can be attributed to $900K in foreign currency impacts and $1.8 million in multi-deliverable deals that couldn’t be recognized because not enough work was completed on the services line to trigger revenue recognition of the software element. The FX impact is just part of the deal with ALTR. One could argue that the services teams need to step it up and get their work done. In any event the end result is a little noise in the quarter, but billings growth of 16% in constant currency shows that the business is still healthy and there are no major changes in underlying demand trends.
On the subject of trends, management was asked if it’s seen any disturbance from macro concerns, specifically in the auto industry where Altair generates a significant amount of business. The answer was that business is still strong and that design and simulation software is a relatively low percentage of an auto manufacturer’s costs but of immense strategic importance. With roughly a dozen new auto companies sprouting up in the electrical vehicle market, and greater focus from established companies on electric, Altair feels good about demand from autos.
There were a lot of questions about the Datawatch acquisition, which makes sense given that the stock fell sharply the day after it was announced. The short version is that management doesn’t expect to divert significant resources to growing in the financial markets where Datawatch’s products are mostly used now, but will continue to support current customers, especially the larger dollar value ones and those where cross-selling opportunities abound.
Management also spoke at length about the rationale for the acquisition, saying that in the machine learning, AI and simulations areas where Altair is focused that data sciences play a huge role. Data science requires data prep, and that’s Datawatch’s specialty. Having covered Datawatch in the past (I added it to this portfolio in 2017) I have to agree. Management offered several examples of existing customers (none by name) that have been asking for the capabilities that Datawatch’s software offers and asserted that by rolling Datawatch into Altair’s units-based pricing model the company believes it can remove much of the friction that has held Datawatch back in the past.
Management also clarified that Datawatch’s streaming analytics tools do have some presence in IoT markets including automotive (connected and autonomous vehicles), manufacturing (production planning, quality control), energy (smart meter and grid monitoring, oil and gas drilling), transportation, logistics and retail markets. Those markets haven’t historically been a focus. Now they will.
Altair management gave full-year 2018 revenue guidance of $378 to $380 million, which is about $1.4 million shy of consensus, an amount that’s accounted for in the Q3 miss. No guidance has been issued for 2019, but to put out relative numbers Datawatch is expected to deliver $55.5 million in revenue (up 18.4%) while Altair has been expected to deliver $430 million (up 12.8%). Once the deal is closed we should get more accurate guidance from management.
I think the selloff that followed the Datawatch acquisition was overdone and may have reflected some programmatic trading that took ALTR lower than it should have. I’m moving back to buy since the Q3 report suggests there are no major issues that the Datawatch acquisition is trying to cover up, and that there are in fact significant opportunities to pursue with Datawatch in the fold. Management will be challenged to execute, as with any acquisition, but at this time and at the current price, Altair looks like a good deal. BUY.
AppFolio (APPF) is unchanged over the last two weeks and seems to be firming up after dipping into the low 50s two weeks ago. As I wrote last week the story is that AppFolio is a good company with terrific top- and bottom-line growth. In the last quarter revenue was up 32% and EPS rose 50%, to $0.16. It just trades at a premium to peers, and in this market that’s not an advantage. We’ll keep holding and wait for the next updraft. HOLD.
Apptio (APTI) was volatile after reporting last Monday but, like AppFolio, appears to be firming up. Shares rose 2% this week. This is a stock I’d like to move back to buy once we see a stronger trend emerge. Keep holding for now. HOLD.
Arena Pharmaceuticals (ARNA) reported last night and other than a few minor updates it was a non-event given the depth of the update from the October R&D day. The big picture is a well-funded company ($562 million in cash) with a wholly-owned pipeline of potential blockbuster candidates. But it’s going to take time before any of them hit the market. Because of the potential, the stock should have a floor under it around this level. Upside? In the near term, probably not that much, unless new partnerships and/or an acquisition is announced. Further out? A lot of upside potential, and that should keep investors interested. If all progresses as expected the company could have four treatments ready for market by 2022-2023. The image below shows the current state of the four main assets and what they’re indicated for.
Management has been working with the FDA and is in the process of finalizing details of upcoming trial designs. In terms of timing, the closest data readout will likely be from the Etrasimod Phase 2 for PBC sometime in 2019. We should also get to see the Phase III study for Etrasimod for UC start in mid-2019 and get an update on the Crohn’s program as well. The three Ralinepag Phase III studies are beginning to enroll, with one starting now and the other two in the first half of 2019. Data should start to come out in mid-2021. The newest asset, APD418, is likely to enter the clinic in 2019. We should get an update on that asset when management is in Chicago this weekend.
Again, a lot of potential. Investors just have to be patient. If you can’t be, it’s likely best to direct your money elsewhere. If you can be, Arena remains a buy. Just average in. BUY.
AxoGen (AXGN) was flat this week but is up 12% over the past two weeks after beating expectations and restoring modest confidence in the growth story. Management also lowered expectations for 2019 by guiding for 35% revenue growth, which was probably wise even if it sees potential for the 40% growth that it had alluded to earlier in the year. As with many of our stocks, the trend isn’t yet strong enough to move back to buy. But we don’t need to walk away either. Keep holding. Management will host an Analyst day on November 19, a week from Monday. That will be an event to pay attention to and I will update you afterward. HOLD.
Bottomline Technologies (EPAY) has been one of our more steadfast positions this fall. It reported Q1 fiscal 2019 results last night in which revenue rose 12.2% to $102.4 million (beating by $2.5 million) while adjusted EPS of $0.33 was in line. Subscription and transaction revenue is driven by the company’s cloud platforms and was up 15% to almost $70 million (68% of revenue). Bottomline landed 26 new institutions for its Paymode-X payments platform, including a partnership with TD Bank which will offer Vis Payables Solutions on the platform. Seven clients selected the company’s cloud-based legal spend management solution and a few others, including Mirabaud, Interactive Investor and Mercedes-Benz, signed up for other solutions.
The company has also recently closed a deal with Visa to tie customers into Visa’s B2B Connect platform. Visa is obviously a big player in the global payments market and with this relationship Bottomline significantly expands its reach in areas like secure cross-border payments. The company was asked about M&A potential and the answer is that it’s interested in assets that would expand its competitive differentiation. With recent investments in digital and open banking it’s fair to assume Q2 Holdings could be a potential target, though that would be a sizeable transaction.
Management continues to believe it can grow subscription and transaction revenue by 15% to 20% for years, with potential to hit 25% growth at times if things go very well. It currently has seven banks planning to go live over the next three quarters, with most expected to go live in the June to September 2019 time frame. That should help growth accelerate modestly as it works through the first half of 2019.
The stock is trading down sharply this morning in what appears to be a gross overreaction to a perfectly fine quarter. I’m keeping at buy and think there could be good short-term gain potential if and when the stock bounces (it should). BUY.
Chefs’ Warehouse (CHEF) reported solid Q3 earnings last Friday and the stock has been one of our best performers since, rising by 7% over the past week and 9% over the past two. As I’ve said before this is more of a growth and value stock than a pure growth stock, which makes it a good match for this market. Keeping at buy but try to average in on pullbacks. BUY.
Everbridge (EVBG) reported Monday night and I sent out a Special Bulletin on Tuesday. As you know I’ve been a fan of this stock and think the market opportunity remains huge, especially relative to the company’s size. The market agrees; Everbridge is up 12% over the past week and 15% over the past two. In this market that’s a tremendous show of strength. If you don’t own any you can pick up a few shares, preferably on weakness. For those that are still maintaining their position and are a little hesitant to buy anything in this market, just keep holding. HOLD.
Goosehead Insurance (GSHD) also reported on Monday and while I liked the quarter, despite management’s somewhat gloomy guidance on housing (and therefore some headwinds in homeowner policy referrals), the market hasn’t responded by bidding shares higher. The stock is down 12% over the past two weeks and is now back to around 30. I think this is still an opportunity to average in to a position that should strengthen over the course of 2019. Revenue should grow at around a 40% annual pace for the next couple of years (then in the mid-to-high 30% range) while adjusted EPS growth should be well above 50% and surpass $1.00 by 2022. There is also potential for special dividends, which I have heard from a few subscribers is a questionable use of cash. While I’m not sure I agree with that view – it all depends on cash flow, profitability, etc. — I would think a modest dividend would be viewed as a shareholder-friendly move. We’ll see! Continue to average in. BUY.
IntriCon (IIN) reported Monday and was all over the map on Tuesday before closing near support at 40. Shares have moved a little higher since but certainly aren’t looking strong enough to move back to buy yet. Sit on your current position. HOLD.
Q2 Holdings (QTWO) reported Tuesday and I sent out a Special Bulletin detailing the results on Wednesday. The stock’s trend is up, but it’s quite choppy (up 2% over the past two weeks). Q2 is another stock I expect to move back to buy, just not yet. HOLD.
Rapid7 (RPD) reported better-than-expected results on Tuesday and shares jumped higher on Wednesday. They gave back some of the gain yesterday but we’re within 10% of the stock’s all-time high so all things considered it’s looking good. I sound like a broken record here, but as with many of our other cloud software stocks, Rapid7 is a hold until we see more of an uptrend emerge. HOLD.
Repligen (RGEN) was last Friday’s new addition and my report came a few days after the company reported blowout Q3 results. We started with a half position given the mixed signals of a weak market but a very strong stock. Shares have continued to advance over the past week on higher-than-normal volume, suggesting a decent amount of money is moving in.
The high-level story with Repligen is that the company designs and sells bioprocessing technologies that make it more efficient to manufacture biologic drugs. These solutions help customers overcome capacity, cost, quality and time pressures. Repligen is as much a partner as a supplier to its customers (who are large biopharmaceutical companies and contract manufacturing organizations) given the heavily regulated nature of bioprocessing and the strategic importance its products play in the drug approval and manufacturing process. Its solutions help set a higher bar for making complex treatments, including monoclonal antibodies (mAbs), recombinant proteins, vaccines and gene therapies.
It’s an interesting behind-the-scenes way to get exposure to the biologic drug market. And Repligen is growing quickly too. Management expects 35% to 37% revenue growth this year and EPS of $0.73 (at the midpoint of guidance). Keep averaging in. BUY A HALF.
Please email me at tyler@cabotwealth.com with any questions or comments about any of our stocks, or anything else on your mind.
