If you read the Wall Street Journal you may have seen this story on small caps this past week:
I saw it, read it, and was struck (again) by how a headline can be so misleading. This one suggests there is a large small-cap correction going on, and it tosses all small-cap stocks into one, sliding bucket!
Sure, you can’t go too deep when talking at a high level about a particular asset class. And you need a headline that will attract eyeballs. But still, this just rubs me the wrong way. Are small caps really sliding? Is that the concern right now?
Yes, the S&P 600 Small Cap Index is down 3.3% over the past two weeks while large caps are flat. And yes, large caps are trading closer to the high end of their most established trading range than near the low end (small caps are in the middle of theirs, as I’ll show in a second).
But year-to-date, the S&P 600 Index is up 12%, exactly the same amount as the S&P 500.
And in many individual stocks I’d say the action is starting to lean more towards frothy, than bearish. That’s why I’ve been pulling on the reins in recent weeks, moving more stocks to hold and suggesting taking smaller positions if you’re buying.
Take my last three recommendations.
Since March 1, Upland Software (UPLD) is up 16%.
Since February 1, Avalara (AVLR) is up 37%.
Since January 7, CareDx (CDNA) is up 57%!
For sure, we have a couple dogs right now too. Chefs’ Warehouse (CHEF) and Goosehead Insurance (GSHD) are drags in our portfolio. And Bottomlline Technologies (EPAY) and Repligen (RGEN) have yet to contribute to our average gain of almost 70%.
But plenty of other stocks are trading at or near all-time highs, including Rapid7 (RPD), Everbridge (EVBG) and Q2 Holdings (QTWO).
Taking a look at the small cap chart we’ve been watching, which plots some basic support and resistance lines on the S&P 600 Small Cap Index (just like in the S&P 500 index chart above), this little pullback in small caps came after they hit a price level where a pause seemed likely.
They are now in an established trading range, and as I’ve been saying (fully admitting that I could easily be wrong) I expect small caps to bounce around in this range for a while.
To me, we’d have a “concerning small stock slide” if the S&P 600 Index were to trade down to 920, then fall to 900, then crack below that. It would be very concerning if small caps did this while the S&P 500 stayed above the 2580 to 2630 range. That would mark a significant divergence to the downside, while taking out some important technical levels for small caps.
But that’s not the case today. So my message to you is this; enjoy the rally in many of the small caps you own, but recognize that there are some signs of frothy action out there.
With that out of the way, I wanted to share a word on biotech and MedTech stocks.
Recall that many of these stocks declined in the first week of March on news that FDA leader Scott Gottlieb will resign in April. This past week we learned that National Cancer Institute (NCI) director Ned Sharpless will become acting FDA commissioner, and that has helped both biotech and MedTech stocks rebound.
In addition to deep industry experience and publication of numerous papers on stem cell research, Sharpless also developed a glowing mouse infused with firefly luciferase to help scientists visualize formation and progression of spontaneous cancers! Among many other accomplishments, his lab (in 2009) also identified a biomarker shown to be a clinical outcome predictor in kidney transplant, a market that portfolio holding CareDx (CDNA) is active in.
Sharpless has also helped start two biotech companies. The first is G1 Therapeutics (GTHX), which sports a $600 million market cap. The second is Sapere Bio (not publicly listed).
Dr. Sharpless was touted by Scott Gottlieb, as well as Health and Human Services Secretary (HHS) Alex Azar, as a terrific leader for the FDA in either a temporary or more extended capacity. Azar stated that the FDA will continue to focus on drug approvals and fighting the opioid crisis, while battling the rapid rise of e-cigarette use amongst young people.
In short, he sounds like a smart guy that’s market-friendly and will support commercialization of new drugs, treatments and technologies. This should be neutral-to-good for biotech and MedTech stocks in the short-term, and I expect to cover more of these types of opportunities in 2019.
Changes this week
CareDx (CDNA) moved to HOLD
Everbridge (EVBG) moved to HOLD
Updates
AppFolio (APPF) is trading back up near a five-month high (up 13% over the last two weeks) after recovering from its post-Q4 earnings report dip. There’s no new news, and we don’t know if some of the strength can be attributed to management starting to buy back shares. I think that could be part of it, but that most of the momentum is due to the broader move up in tech/software. I’m keeping at Buy. AppFolio sells software to small and medium-sized businesses in the property management (most of its business) and legal industries (a much smaller part of revenue). BUY.
Arena Pharmaceuticals (ARNA) gave a good business update a couple of weeks ago, but along with most biotech and MedTech shares, shares declined on news the FDA leader Scott Gottlieb will resign. News that Ned Sharpless will become acting FDA commissioner has helped both biotech and MedTech stocks rebound. For its part, Arena has moved sideways as if glued to the 45.5 price level. Late last week management also presented new Phase 2 data for etrasimod and olorinab at the 14th Congress of European Crohn’s and Colitis Organisation (ECCO). The data doesn’t change the story significantly and it’s still full speed ahead with both assets (refer to last week’s update for things to watch in the year ahead). I’ve had Arena at Hold given the big run and will continue to stick with that rating for now. HOLD.
Avalara (AVLR) sells automated sales tax compliance software. If you have any doubt about whether the trend is toward more legislation requiring online businesses to remit sales tax, just look at this table from Avalara’s website. It shows that 39 of 52 states (including D.C. and Puerto Rico) have nexus laws affecting remote sellers.
It’s likely only a matter of time before it’s 52 of 52. That’s the big picture trend. If that resonates with you then you should probably pick up a few shares. If you don’t know what I’m talking about, read the February Issue of Cabot Small-Cap Confidential, which explains how the Supreme Court’s South Dakota vs. Wayfair decision has accelerated legislation requiring online businesses to collect and remit sales tax, and how that feeds directly into Avalara’s wheelhouse.
Another potentially bullish trend: In Avalara’s 10K Annual report, the company disclosed that it was required to reclassify $170,000 (June quarter), $392,000 (September quarter) and $493,000 (fourth quarter) from “Interest income” into “Subscription and returns revenue.” Where does this revenue come from? It’s the interest Avalara is generating on funds that it held between the time of collecting from customers and submitting to the taxing authorities. As the business scales up this could be a very nice source of incremental revenue (the trend appears to be up!). The stock broke out in mid-February and has kept climbing since. We’re up around 36% since the first of February. Average in. BUY.
Bottomline Technologies (EPAY) is still consolidating in the 42 to 52 range (closer to the high end, now). As I’ve been saying I think the call here is just to stick with it and let the business, and the stock, regain momentum. Once it does, I’ll move back to buy. HOLD.
CareDx (CDNA) specializes in noninvasive diagnostics solutions for heart and kidney transplants. The company is applying the latest advancements in genomics and bioinformatics technology to improve the lives of organ transplant patients. It reported last week, shot up to a new high, and has kept climbing since. It’s a beast. Fourth quarter revenue was up 88.1% to $23.5 million while EPS of $0.01 beat by $0.10. AlloSure, a non-invasive blood test, continues to be the main growth driver and thus far has provided results to 60K patients, which represent around 3% of the total population living with a kidney transplant. Management gave 2019 guidance of $105 million to $107 million (up 37% to 40%). That assumes product revenue growth of around 20%, AlloSure revenue up 100%, and AlloMap revenue up mid-single digits. You can peck away at a few shares here and there but given this run it feels wise to hold off on any big purchases. Moving to Hold until it takes a breather. HOLD.
Chefs’ Warehouse (CHEF) jumped out of the gate quickly on Monday and looked poised to recover its drop from the previous week, but the trend turned back down on Wednesday. We haven’t cracked the 30 level that would mark a real bearish move (in my opinion) so we don’t need to step aside just yet. And as I said last week, this has been a reliable area to buy (look at October and December moves off 30). That said, if we go down much more, we’ll likely step aside to avoid taking a loss on this position. BUY.
Codexis (CDXS) pulled back after its earnings report two weeks ago but found support above its 50-day moving average line and is up a few percentage points this week. Recall that 2018 revenue was up 50% (to $61 million) and the business is tracking about as expected as management builds out a portfolio of revenue-generating assets. Codexis is a protein engineering company that specializes in the discovery, development and commercialization of novel proteins, both as proprietary products and in partnership with customers. Proteins are the large, complex molecules that do the lion’s share of the work in your cells and are essential for all living organisms. The company’s 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. The stock’s long-term trend is still pointing up. BUY.
Everbridge (EVBG) made another new high on Monday and looks like it could run up a bit more before pausing. That said, it’s made a very nice move year-to-date (up ~35%) so it’s not time to back up the truck. I’ve had a buy for a while but am moving back to Hold just to reduce the risk of a quick loss on new positions. This week the company launched a new solution, Crisis Management, which integrates with Everbridge’s Critical Event Management (CEM) suite and helps organizations dynamically manage the lifecycle of a critical event, from response to recovery. The key advantage of the new solution, in the company’s words, is that it allows customers to move from automating the management of communications around an incident, to managing the incident itself. Everbridge has done a great job of releasing new solutions that expand its market and drive upsell and cross-sell activity. HOLD.
Goosehead Insurance (GSHD) remains under pressure this week and is now well off the multi-month high of 34 struck in late-February. Recall that the company reported last week. Revenue missed by a hair (up 32.3% to $14.7 million) but EPS of $0.01 missed by $0.03 on higher operating expenses, which management had hinted might pressure earnings on the last quarterly call. Despite the miss, the growth story remains intact. Management gave forward guidance, saying 2019 revenue should grow by 33% to 41% ($80 million to $85 million, consensus was for $80 million). No EPS guidance was given so I suspect analysts will hold EPS estimates steady at about $0.64 (up 105%) given the higher-than-expected operating expenses. Shares may have fallen this past week simply because it’s thinly traded and a lull in buying activity tends to have a greater adverse effect in thinner stocks. It’s also possible more data showing the housing slowdown continues (new home starts down ~7% in January) is being interpreted as an ongoing headwind (GSHD gets referrals from housing sales). In any event, the stock doesn’t look great and will be moved to hold if it closes below 24. For now, you can keep averaging in. BUY.
Q2 Holdings (QTWO) was moved back to Buy two weeks ago after management spoke about the size of the addressable market (up to $8 billion from $3.5 billion in 2014) and goal to grow at 20%, with gross margins north of 40% and adjusted EBITDA margins of 20% to 25%, versus the 7% estimated this year. That suggests a lot of leverage remains in the business model. While the market isn’t just going to reward investors today for something that management hasn’t yet accomplished, the reality is if you wait until after the fact you will likely be paying a lot more for the stock. Let’s hope management gets the job done! Use this consolidation phase to average in. BUY.
Rapid7 (RPD). The 2019 RSA Security Conference just wrapped up, so analysts have been publishing lots of notes (many bullish) on security stocks over the past week. The punchline is it’s a strong industry, and that strength is likely to continue given increasingly complex IT environments (cloud, mobile, etc.), lots of bad actors out there, new compliance requirements, a tight labor market and demand from organizations for platforms that span threat detection, visibility, response automation, orchestration and security analytics. There are a lot of security stocks doing very well, and Rapid7 is right in the mix. Shares are trading near an all-time high. I’ve had a Hold for a few weeks given the big move year-to-date. We’re up around 84% on our position. HOLD.
Repligen (RGEN) has bounced back this week and is now basically flat over the last two weeks. There’s no new news, so I’ll repeat what I said last week with respect to M&A activity and Repligen’s position in the bioprocessing market. Last week I said, “On the M&A front it’s noteworthy that Danaher (DHR) has agreed to acquire GE Biopharma from GE Life Sciences for $21.4 billion. This should be a good acquisition for Danaher (far too big for me to cover given the $89 billion market cap), but more importantly speaks to the long-term growth potential in the bioprocessing market. The biological drug market is expected to grow around 9% annually for several years as drugs penetrated deeper into Asia, biosimilars rise to power and cell and gene therapies become more prevalent. With drug production volumes going up, bioprocessing technologies are in high demand. Repligen has existing contracts with GE which should transfer over to Danaher, and Repligen’s current relationship with Danaher in continuous processing using OPUS pre-packed columns should be unaffected. Of course, things change, so there are no guarantees. I’d be remiss not to point out that Repligen remains one of the few pure-play suppliers in the bioprocessing market and is likely part of any discussion by bigger players when considering acquisition potential.” Keeping at Buy. BUY.
Upland Software (UPLD) is helping me look a lot smarter than I really am given that it just shot up 17% over the two weeks since I recommended it! Highlights from the Q4 earnings report: Revenue was up 63% to $45.2 million while adjusted EPS of $0.58 beat by $0.09. For the full-year fiscal 2018, revenue was up 53% while adjusted EPS rose 64% to $1.70. Much of this growth was through acquisitions, but organic growth is trending up too (6%, 6%, 7% and 10% over last four quarters, respectively), which is a big deal as it suggests previously acquired businesses are starting to drive new growth (very bullish long-term signal). Management gave bullish 2019 guidance for revenue of $194.8 million to $198.8 million, well ahead of prior consensus of $190 million (not factoring in new acquisitions). Management also announced a revised go-to-market strategy. The company now has seven enterprise solution suites, each of which includes a bundle of solutions for a particular functional area, such as Customer Experience Management, Enterprise Sales Enablement, Project and Financial Management, etc. Finally, Upland talked about how investors should view the business, saying it is about three platforms; (1) an M&A platform, (2) a product platform, and (3) an operating platform (UplandOne). And that it’s benefiting from three big trends; (1) demand for automated enterprise solutions, (2) transition to cloud software, and (3) VC funding chasing the first two trends and creating new companies that become acquisition targets for Upland. Keeping at Buy, just be sure to average in. BUY.
