Apparently, we’re in a raging bull market for small caps.
You wouldn’t know it if you looked at a chart of the S&P 600 Small Cap Index, which is till trading in my expected range.
And honestly, if you looked at any of the small-cap sector ETFs, you wouldn’t see anything all that different from the chart above.
Yet this week, all of our stocks are up (with the exception of one that is flat). And our average gain for the week is just over 4%.
Digging through the portfolio there’s a lot to celebrate. Goosehead Insurance (GSHD) is staging a comeback (+17% this week) and is back above its 50-day line.
New recruit Upland Software (UPLD) is up a couple more points (+19% since March 1) and teasing with a fresh high while Avalara (AVLR) is just cranking, making new highs almost daily and +41% since February 1.
Speaking of cranking, have you seen the charts for Everbridge (EVBG), Q2 Holdings (QTWO) and Rapid7 (RPD)?
New all-time high (+390%). Almost new all-time high (+197%). New all-time high (+99%).
Our recent MedTech stock: CareDx (CDNA), just added on January 1, is +64%. New all-time high.
Both Codexis (CDXS) and Repligen (RGEN), added in December and November, respectively, are finally in the black after a rough start (+9% and +4%, respectively).
Even Bottomline Technologies (EPAY) and Chefs’ Warehouse (CHEF), which aren’t doing all that great (-8% and +2%, respectively), feel solid given the context of what else is going on in the portfolio. Arena Pharma (ARNA), our sole biotech stock, has calmed down lately (+17%) but hasn’t cracked through any major technical levels yet.
And AppFolio (APPF), which was moved back to buy a few weeks ago (+156% since I added it in mid-2017 and +18% over the last two weeks), looks like its running hard to catch up with the pack of cloud software stocks that left it in the dust in January and February.
What the heck is going on? How can so many of these small-cap stocks be flying when the broader small-cap index is just moving sideways?
There’s little doubt that the Fed’s decision to hold rates steady this week and signaling that it didn’t expect to raise again until 2020 (and just once at that) is having a positive impact on stocks. In concert with that news came an update that the Fed plans to stop shrinking its $3.8 trillion balance sheet later this year. The one two punch suggests rates should hold pretty steady for the next year. And the market likes certainty. But this is just the icing on the cake.
Really it comes down to stock selection and being in the right places at the right time. Both software and MedTech have treated us well for years, and I like the secular growth trends in these two areas of the market looking forward too.
In my 2019 Small-Cap Forecast I wrote the following regarding software stocks:
“That all said, with global growth slowing and corporate costs rising, it’s likely that we’ll see a narrower group of software stocks outperform in 2019. Therefore, stock selection will play a greater role in small-cap software portfolios in the year ahead. It will be particularly important to focus on small-cap software stocks that have ultra-compelling secular growth stories, durable business models, attractive M&A potential, reasonable valuations relative to growth, and some insulation from cyclical trends, rising interest rates and trade disruption.”
And with respect to MedTech stocks, I said the following:
“In 2019, small cap MedTech stocks should benefit from many of the same big picture trends that helped the entire group in 2018. These include good fundamentals in mature markets, opportunities in emerging markets, and growth contribution from new products/applications … I like MedTech in 2019 because this group of healthcare stocks is relatively defensive, growth is relatively durable, and risks are relatively low as compared to biotech stocks. That’s because innovation/product development is usually more incremental than disruptive, meaning the value of a stock isn’t likely to completely change overnight, as is often the case with a young biotech stock that has just had a treatment either approved or denied by the FDA.”
Despite my somewhat bullish long-term outlook for these sectors, and the market, it’s worth repeating that, from my vantage point, things are getting a little overheated. Not necessarily at the index level (refer to the chart above), but in certain areas (like where we are invested) there’s bound to be a cooling off phase before too long.
Right now, keep new positions small and don’t get fooled into thinking we’re on a one-way conveyor belt higher. If this bull market is to stay healthy and continue, we’ll need to see a pause in leading stocks and some catch up performance from areas of the market that haven’t done much lately.
This isn’t to say there’s nothing I like out there. Just that the leaders are getting stretched. That’s going to push investors to look for names that they passed over in January and February. I think Bottomline Technologies is one such example, which is why I moved back to Buy this week.
And I have a number of small-cap stocks looking really good right now that we haven’t discussed before, a couple of which are the top candidates for our April Issue, which comes out in two weeks.
On to our updates.
There is quite literally no new news with respect to any of our stocks this week, so my comments are quite brief, and mostly about stock action. That’s not unusual given that we’ve just been through earnings season and that’s the time management teams try to get all the good (and bad) news in front of investors.
Changes this week
Bottomline Technologies (EPAY) moved to BUY
Updates
AppFolio (APPF) is still on the rise as it looks to try and make up some of the ground it lost to rapid growth software peers in the first two months of 2019. There is literally zero new news. 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). It’s still a Buy. BUY.
Arena Pharmaceuticals (ARNA) is down over the last month but flat over the last two, which is more-or-less in line with what the broader biotech index (IBB) is doing. We’ve received a bunch of updates so far in 2019, but nothing over the last week. With this little pullback the stock’s less stretched than it was in late February, but it’s also below its 2018 high, which suggests to me it needs to grind it out for a bit before making another new high. Let’s keep Holding. HOLD.
Avalara (AVLR) sells automated sales tax compliance software. The company went public last June at 24 and was smoking hot right out of the gate, trading up near where it is now (mid-50s) before falling back toward 30 by the end of 2018. Today, the stock is creeping back up toward its prior high, and valuation, so it’s worth being a little careful in terms of new position sizing (i.e. keep new positions smaller, average in, and all that). The best metric we can use is the Enterprise-Value-to-Trailing-Twelve-Month-Revenue (EV/TTM Revenue) ratio since Avalara is relatively new to the public market (i.e. we don’t have a lot of time series data on forward estimates since analysts have only been covering for a short while). The current EV/TTM Revenue ratio is 13.7. By way of comparison, AppFolio and Q2 Holdings have valuations in the same neighborhood, while Everbridge is higher (16.5) and Rapid7 is lower (9.6). Keep new positions small. BUY.
Bottomline Technologies (EPAY) has been on the hold list for a while but I think investors are going to start coming back to the name if the market continues to do well since it’s cheap (EV/Forward revenue ratio of 5.1 is way off the 2018 peak near 7.5) and still a quality business. To really get bullish on it I’d like to see a move above 52.5, and then 57.5. But let’s try to get ahead of a breakout above those levels. Moving to Buy but will quickly pull back to hold if it starts to retreat from overhead resistance. BUY.
CareDx (CDNA) specializes in noninvasive diagnostics solutions for heart and kidney transplants. I moved the stock to Hold last week given the big run since mid-February. I still love the stock but let’s continue to be a bit conservative here. HOLD.
Chefs’ Warehouse (CHEF) is coming off a big retreat from the high 30s down to 30, where it (thankfully) found support for the third time in six months. No net progress over half a year isn’t a great selling point for the stock. But we have seen shares go on big runs. Let’s continue to be patient. The idea with Chefs’ was to add a GARP-y stock (growth at a reasonable price) to our portfolio at a time when there were emerging concerns about economic growth (summer, 2018). It hasn’t hurt us, but it hasn’t helped a great deal either (basically flat since I added it). I’ve had at Buy since I think the next move is up and if we can catch it, we’ll have the flexibility to take a modest profit, or keep holding. BUY.
Codexis (CDXS), which is a protein engineering company that specializes in the discovery, development and commercialization of novel proteins, has a habit of running quickly to new highs then making a significant retreat. But the overall trend is one of higher highs and higher lows—you just want to try and buy at the beginning of one of those runs, or toward the end of one of those retreats. Of course, there’s no guarantee that pattern will continue. Right now, the stock doesn’t look to be any either extreme, so it’s not time to do anything extreme, just add a few shares here and there. BUY.
Everbridge (EVBG) is delivering next-level performance (up ~38% year-to-date), with a valuation to match (EV/Forward revenue of 12.4 is in line with 2018 high). As I’ve said before there is scarcity value here so it’s not necessarily a red flag that the stock’s so hot. But, it’s not time to load up on shares either. I moved to Hold recently so we can just watch and enjoy, and I’ll stick with that rating for now. HOLD.
Goosehead Insurance (GSHD) was doing well in February but didn’t respond well to its earnings report a couple weeks ago. The stock didn’t totally crack, and in fact held up above its December low. But the decline wasn’t confidence inspiring. Over the past week things are much improved. The stock is up double digits and trading right around its 50-day line. Keep averaging in. BUY.
Q2 Holdings (QTWO) was moved back to buy three weeks ago on addressable market expansion and a nice growth roadmap update from management (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). The stock’s been digesting its gains from January and February, but I think has more upside purely on valuation. The current EV/Forward Revenue ratio of 9.9 is below the 2018 peak of 11. Keeping at Buy. BUY.
Rapid7 (RPD) is an interesting case because the stock is trading at all-time highs on both price and valuation (EV/Forward Revenue ratio of 7.6, versus 2018 peak of 7). The key difference here is that the stock has historically traded at a discount due to a hybrid delivery model (cloud and on-premise) and limited product offerings. That’s changed. Rapid7 has broadened its solution offerings and transitioned to the cloud, and both customers and investors like what they see (growth is picking up). There could be more upside in the near term, but I moved to Hold recently just so we can enjoy the run and not stress about buying at a near-term peak. HOLD.
Repligen (RGEN) was up and down late last year but has returned to fighting form in 2019. The uptrend here isn’t going to blow you away, and a big three-day selloff last week did raise some eyebrows. But, big picture, I think this is a good stock to own given its pure-play exposure to the bioprocessing market. Don’t rule out M&A activity (remember Danaher (DHR) has agreed to acquire GE Biopharma from GE Life Sciences for $21.4 billion). 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. Keeping at Buy. BUY.
Upland Software (UPLD) took off right after I recommended it (with the help of a great earnings report) and has continued to move incrementally higher over the last two weeks. There’s no new news this week. Upland is one of the few software stocks under the $1 billion market cap threshold that’s really performing well right now. I think that’s drawing eyeballs from small-cap fund managers looking to add a position that could drive some outperformance. And the uptick in organic growth (6%, 6%, 7% and 10% over last four quarters, respectively) from a company that’s mostly been growing through acquisitions adds another interesting dimension to the story. Keeping at Buy, just be sure to average in. BUY.
