It’s not often that we go from talking about the best of times to the worst of times in a few short months.
In 2018 there were 18 new all-time highs in the S&P 500!
But most of us are focused on how 2018 was “the worst” in this dimension or that.
The worst year since 2008. The worst month (December) since 1931. The list goes on.
Markets like this restore our sense of humility and respect for the wisdom of crowds. And they reinforce what we all know deep down inside—that nobody knows where the market is going to go next.
I think it’s fair to say most market observers were not surprised that stocks retreated in late-2018. The market had seemed poised for a pullback after all. But the magnitude of the decline certainly caught most of us off guard. And the wild nature of price swings (i.e. volatility) gave the impression that the market had become unhinged.
Because we all like to blame something specific for the correction it’s comforting to point the figure at the pace of the Fed’s rate hikes (and projections for future hikes, which are no longer in the equation after mid-morning today), Trump’s trade war, and concerns about slowing growth in certain pockets of the world economy.
But in reality, there are always major issues lurking out there. What has changed since September is that the market is no longer capable of climbing that proverbial wall of worry. It is just sliding down it.
With a little luck, things will be better in 2019. Stocks certainly look like a good value right now. But fourth-quarter 2018 earnings will be crucial in terms of helping us understand if forward revenue and earnings estimates (which have come down in recent months) paint an accurate picture of where we are headed.
There is likely to be some carry-over benefit from the corporate tax cut that was implemented in 2018. But as we move into 2019 results will be based more on the blocking and tackling that separate the really good companies from the just so-so ones.
One potential positive for small caps is that the asset class has less exposure to international trade than large caps. While growth in the U.S. is likely to slow some, and access to capital is tightening, this domestic focus should still provide some insulation from trade headwinds.
In Cabot Small-Cap Confidential we try to look through all this short-term volatility and focus more on long-term results. We’re investing in stocks, not trading them.
In many ways 2018 was like a harvest year. This year, 2019, is shaping up to be more like a year where we plant the seeds to harvest later on.
I’ll get into more details when my 2019 Small Cap Outlook comes out later in the month. But suffice to say, despite the crazy market, I see a lot of opportunities out there!
Changes this week
Altair Engineering (ALTR) Moved to Sell Second Half
From Monday’s Special Bulletin
Codexis (CDXS) Moved from Buy First Half to Buy Second Half
Repligen (RGEN) Moved from Buy First Half to Buy Second Half
Updates
Altair Engineering (ALTR) sells simulation software and is a play on the digital twin theme. Demand for simulation software has been on the rise but more recently concerns about global trade and exposure to the economically sensitive automotive market, plus a dilutive acquisition, have hurt the stock. We’ve already reduced our position size by half but the stock isn’t looking any better. I suspect we can come back to this stock at a better price, at a time when the downside risk is lower, and/or when the stock is in a more constructive trend. Let’s step aside completely and put Altair back on the watch list. SELL SECOND HALF.
AppFolio (APPF) sells cloud-based software tailored to two industry verticals: property management and small legal businesses. It has an efficient business model characterized by relatively low customer acquisition costs and high revenue/profit per customer. The stock has been grinding sideways since the beginning of November, which is a relative win in this market. Keep holding. As I’ve stated many times, I wouldn’t be remotely surprised to wake up to news that AppFolio has been acquired, or that it’s breaking into a third business vertical, or making a significant acquisition to boost its presence in the legal market. HOLD.
Arena Pharmaceuticals (ARNA) is a development-stage biotech stock and thus its value is derived from its pipeline. First revenue, assuming successful Phase 3 trials, won’t be for several years. The company recently out-licensed its ralinepag asset to United Therapeutics (UTHR) for up to $1.2 billion in exchange for an $800 million upfront payment, a $400 milestone payment, and tiered low double-digit royalties on global sales. That cash will help Arena move other assets, including etrasimod and olorinab, through the pipeline. The stock has held relatively steady and M&A activity, like Bristol-Myers Squibb’s (BMY) acquisition of Celgene (CELG), announced this week, is helping investors stay tuned into biotech stocks. BUY.
AxoGen (AXGN) was sold at the end of 2018. No update. It’s on my watch list for future inclusion if the stock shapes up. SOLD.
Bottomline Technologies (EPAY) is a play on digital business-to-business payments with a little digital banking exposure mixed in. Revenue should be up around 8% this year and 10% in 2019, while EPS should expand from $1.45 this year (up 14.2%) to $1.69 next (up 16.6%). The stock is still looking for a bottom after it was punished in November. There was a little uptick just before the end of the year, but it’s a little early to say with confidence that the next big move will be higher. Keep pecking away at it but don’t go in too heavily, especially if you already have a decent-sized position. While there could certainly be more downside Bottomline is one of those stocks I’m highly confident will come back and perform well when the market firms up. BUY.
Chefs’ Warehouse (CHEF) supplies independent restaurants with food and other supplies. It’s a very difficult business model to emulate and while there are larger competitors (like Sysco and U.S. Foods). The stock’s kind of a growth plus value stock and it held up reasonably well during the market swoon of late 2018. Given the pullback in December I moved the stock back to buy, and I still like that call today. Shares bounced right off their 200-day line (at 30) before Christmas and are up around 8% since. BUY.
Codexis (CDXS) was just added to the portfolio at the beginning of December, which as you know was not a good time to be buying stocks. I recommended starting with a half-sized position and decided to up that to a full position on the last trading day of 2018 (I sent out a Special Bulletin advising that you fill the other half of your position). In terms of performance tracking, our reference price is now the average of the stock’s price (using the average of the daily high and low) on each of the respective buy dates (see table of portfolio results below). My call to buy more wasn’t exactly a bottom call, more that we’re now back to the stock’s 200-day line, where it hasn’t been since the middle of 2017, and, technically, this looks like a good time to buy.
As you know I like the fundamental story. Codexis is a protein engineering company that specializes in the discovery, development and commercialization of novel proteins. These engineered proteins (also known as biocatalysts and/or enzymes) are used in a wide range of industries to make manufacturing processes faster, cleaner and more efficient. Codexis’ CodeEvolver platform helps it engineer novel proteins that are better than naturally occurring ones, and it’s finding success in drug development, novel biotherapeutics, food and nutrition, and molecular diagnostic markets. One example of how its technology is being applied is in the creation of a better-tasting stevia sweetener. BUY SECOND HALF.
Everbridge (EVBG) is hanging in there and is one of the few software stocks that’s within spitting distance of a 52-week high. A little forewarning, though—there could be some short-term impact from the government shutdown given that Everbridge’s critical event management software is FedRAMP authorized and that should help more agencies adopt it. But provided we don’t melt into total chaos in Washington, the growth outlook for the stock shouldn’t be affected. Swift and appropriate responses to natural disasters, active shooter events, terrorist attacks and cyber-attacks aren’t really things anybody on either side of the isle is looking to move away from, I shouldn’t think. And Everbridge helps businesses and government agencies do this better than any software platform out there. BUY.
Goosehead Insurance (GSHD) is one of those extremely rare examples of a rapid growth stock in a very slow-growth industry. The company sells personal lines insurance and is disrupting the market by deploying a cloud-based sales and support platform coupled with a hybrid corporate and franchise distribution model. Most policies are either homeowner or auto policies, both of which are relatively sticky products. Goosehead represents over 80 carriers (Progressive, Travelers, Safeco, MetLife, etc.) so it’s able to offer clients the best policy for their situation. It’s also growing at a blistering pace; revenue should be up over 40% this year and next and has potential to accelerate as Goosehead scales the business up. In comparison, its industry typically grows in the low single digits. The company is also profitable, with EPS expected to hit $0.27 in 2018 and $0.35 in 2019. And management hinted at a special dividend in Q1 2019, which implies shareholders should receive some type of dividend in future years as well. In the last quarter management said the slowdown in the housing market did dent its pipeline of new policies, but that it had made adjustments and that it doesn’t expect a lasting impact. Keep averaging in. BUY.
IntriCon (IIN) was sold at the end of 2018. No update. It’s on my watch list for future inclusion if the stock shapes up. SOLD.
Q2 Holdings (QTWO) was moved back to buy a few weeks ago since the risk-versus-reward potential looks attractive. It is a digital banking software stock that’s enjoying strong end-market dynamics as financial institutions are enjoying improving net interest margins. Revenue is expected to accelerate from 24% in 2018 to over 27% in 2019 as it goes live with larger installations. This should also help margins and drive EPS up from $0.11 this year to $0.28 in 2019. The stock received an upgrade from Stephens to “overweight” this week. BUY.
Rapid7 (RPD) is a security software stock and it’s been holding up relatively well. Security is one of those areas of software that’s a must-have, which makes it somewhat defensive. Expect 20% revenue growth this year and next, along with an estimated $0.45 EPS improvement in 2019. You can keep buying it. BUY.
Repligen (RGEN) gave back its post-earnings gains (from November) in the month of December, and then some. Like Codexis, this is a stock we started off by taking just a half position in and then added the other half position on the last trading day of 2018. Repligen is a pure-play supplier of bioprocessing technologies that make it more efficient to manufacture biologic drugs, while ensuring high quality and safety standards. It is a leader in areas such as filtration, pre-packed chromatography columns and Protein A ligand manufacturing. These solutions help customers overcome capacity, cost, quality and time pressures. It’s been doing very well due to innovation and growth in single-use technologies, which reduce capital spending for customers. Management will present at the J.P. Morgan Healthcare Conference next Tuesday. BUY SECOND HALF.
