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Small-Cap Confidential
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July 14, 2022

Things were looking up until we received this week’s inflation report courtesy of the June CPI data.

Things were looking up until we received this week’s inflation report courtesy of the June CPI data.

The higher-than-expected reading (headline: CPI +9.1% versus +8.8% expected) has investors worried that a potential soft landing (no/mild recession) could become a hard landing (deeper recession), that inflation could become entrenched, that interest rates will need to go even higher or that some combination of the above will continue to pressure consumers, corporate growth and profits and the equity markets.

While CPI data showed that core inflation is indeed improving (down to 5.9% in June from 6.5% in May) pesky energy (+41.6%), food (+10.4%) and shelter (+5.6%) costs are continuing to be problematic. Shelter costs will likely persist as an issue as new leases are reflecting higher housing costs.

On the flip side, energy costs could easily come down in July data given softening prices over the last few weeks. And there are some other moving pieces that could help the inflation picture improve in the coming months.

The bottom line is that this latest reading didn’t give us the “past peak inflation” look we’d been seeking, but hope is not lost.

In the wake of the CPI data expectations for the next Fed rate hike (FOMC meets the week after next) went from 50 – 75bps up to 75 – 100bps. The odds are shifty on those estimates now, with a 75% chance of a 100bps hike yesterday sliding overnight to now just a 52% chance (remember, the Fed’s current target rate is 150 – 175bps so a 100bps hike gets us to 250 – 275bps).

Either way, the yield on the 10-year is still below 3% so the market is not convinced that the Fed can hike that much further without inducing recession and potentially having to shift to a hold-steady or even rate-cut cadence in 2023. The yield curve spread between the 2-year and 10-year is now firmly inverted at -24bps, which indicates a coming recession.

Turning back to stocks, prior to this week’s CPI release we had already seen some analysts pulling back on forward estimates. That trend is likely to accelerate now. In fact, over the last 24 hours I’ve already seen some more numbers pulled in.

What’s not known is how much of that is already priced into stocks.

For instance, we look at software stocks and they’re already trading below trailing five-year multiples. And the S&P 600 Small Cap Index trades with a forward P/E just above 11. That’s very, very cheap.

In other words, there’s room for revenue and EPS estimates to come down and stocks will still be cheap relative to history.

Second-quarter earnings season will give us some indication of how accurately the market is pricing stocks. But we still won’t have the first read on Q2 GDP (which could help confirm a recession) until later in the month, on July 28. That will come right on the heels of the FOMC meeting. And then we’ll jump into earnings season for our portfolio stocks.

At the moment, we’ve seen pullbacks but no breakdowns in the major indices so we’re not making any big changes in our portfolio. But I’m not opposed to exiting another position or two should market conditions deteriorate.

From the 10,000-foot perspective I continue to see this as a time to be looking for opportunities that will destroy the market when things turn up, and taking partial positions in a few of them. But we’re sure not ready to shift to an aggressive stance just yet.

Recent Changes
DigitalOcean (DOCN) Moves to HOLD

Avalara (AVLR) was the subject of takeover rumors recently (Vista Equity Partners is the rumored potential acquirer). That speculation prompted a 16.4% rally in the stock last Thursday. Speculation has cooled off since but AVLR has held on to the bulk of that gain. Is it a target? Who knows, but it wouldn’t be remotely surprising. Recall that management held an analyst day a couple weeks ago and management reiterated its goal to grow annual revenue at a 20% to 25% clip through 2025. HOLD A QUARTER

CS DISCO (LAW) was gaining momentum last week (stock was up 27%) but momentum has faded this week. With a consumption-based pricing model LAW could see a slowdown in client spend sooner than companies with a pure subscription-priced business model. That said, legal activity will often continue regardless of economic conditions and CS Disco’s platform is an efficiency tool that lowers the total cost of legal services versus other approaches. We’re looking for 30% growth for several years and in the upcoming quarter are expecting to hear more about the Congruity360 acquisition (legal tech and legal request compliance), which could drive large enterprises to adopt LAW’s solutions. HOLD A HALF

DigitalOcean Holdings (DOCN) received a couple of downgrades this week from Morgan Stanley (PT to 45 from 61) and Goldman Sachs (PT to 40 from 54). Both firms cite big-picture risk of slowing software spending heading into a recession and, more specific to DOCN, the company’s consumption-based pricing model (great when clients are expanding spend but vulnerable when clients are cutting spend) and exposure to Europe (likely worse economy than in the U.S.). On the flip side, recall that DOCN management held an investor day in early June during which it reiterated its goal to get to $1 billion in revenue by fiscal 2024 (implies 30%+ growth for several years), reaffirmed 2022 revenue guidance, discussed its strategy to grow its sales force in order to pull in more/larger customers, discussed initiatives to expand the product base, discussed the positive impact of a price increase and talked about M&A goals (one to three deals a year, focused on edge computing, ML and AI). So far, other banks (JPMorgan, Bank Of America, Piper Sandler) remain overweight on the stock. With shares of DOCN now trading near 35 (they had peaked between 48 and 52 in both May and June) and our holding of just a half-sized position I’m currently comfortable with our exposure. That said, I’m watching DOCN and am not ruling out exiting our half position and coming back to it later. Second-quarter earnings are due on August 8. Moving to hold. HOLD
Earnings Date: Monday, August 8

Ingles Market (IMKTA) should be making a dividend payment today ($0.165) to stockholders of record as of July 7. The stock has perked up a little over the last week. Revenue through the first two quarters of the fiscal year has grown 16.6% while EPS is $7.10, up 35%. BUY A HALF

Inspire Medical Systems (INSP) has been mostly making higher highs and higher lows since the stock bottomed (we hope) at 142.7 on May 10. There’s no new stock-specific news. Keeping at buy. BUY

Procept BioRobotics (PRCT) slid back into the low 30s in late June and has remained there since. We’ll keep a close eye on the 28.9 level as that’s where the stock traded down to following the last earnings report (thought it popped right back into the high 30s a few days later). Aquablation awareness and procedure volumes are ramping up and it’s entirely possible that the procedure captures twice the benign prostate hyperplasia (BPH) case mix in two years that it captures today. HOLD A HALF

Rani Therapeutics (RANI) came off its low near 8 in mid-June and is holding up nicely above 11 now. No news to report. There has been some improvement in the broader biotech space. BUY A HALF

Repligen (RGEN) bumped up against overhead resistance in the 170 – 175 area last week and wasn’t able to break through (not too surprising) so we’ll stick with a hold rating for now. One thing to watch out for is that Repligen generated 37.5% of revenue from outside of the U.S. last year and with a strong dollar there could be some foreign exchange headwinds this year. It’s tough to quantify the potential impact, however. And the company also disclosed that 27% of costs were denominated in foreign currencies (i.e. there could be some savings there). HOLD

Sprout Social (SPT) made a quick run to near 70 a couple weeks ago but has pulled back to its 50-day line (near 55) this week. We have an earnings date of August 8. We’re looking for Sprout to grow revenue by more than 30% over each of the next two years and come close to non-GAAP profits in 2023 (2021 adjusted EPS was -$0.13). Sprout is certainly not immune to a slowdown but it’s also a leader in the emerging social media management software space and trades at an attractive valuation. HOLD A HALF
Earnings Date: Monday, August 8

TransMedics Group (TMDX) is last week’s new addition and remains at buy a half. The company is addressing an unmet need in the organ transplantation market for technologies that do a better job at preserving organ quality, assessing organ viability prior to transplant, boosting organ utilization and slashing transplant costs. Its technology is called the Organ Care System (OCS) and it replaces a very old standard of care, cold storage, that is too static to meet the dynamic needs of today’s organ transplant market. TransMedics has layered its National OCS Program (NOP) on top of the OCS. NOP is a nation-wide turnkey solution for transplant enters that provides outsourced organ retrieval and OCS organ management. TransMedics is currently focused on the heart, lung and liver markets. In Q1 2022 revenue grew by 125% to $15.9 million (85% came from the U.S.). On the conference call management increased full-year revenue guidance by $10 million to $59 - $65 million (+95% - 115%). BUY A HALF

Xometry (XMTR) has had a couple of quiet weeks and is still moving sideways in the 30 – 40 range. No earnings date announced yet. With the Platform (acquired last year) factored in the company is seen growing 2022 revenue by 83% to $400 million and delivering adjusted EPS of -$1.05. HOLD

Please email me at with any questions or comments about any of our stocks, or anything else on your mind.

Stock NameDate BoughtPrice BoughtPrice on 7/14/22ProfitRating
Avalara (AVLR)2/1/194082105%Hold Quarter
CS Disco (LAW)9/2/215721-63%Hold Half
DigitalOcean Holdings (DOCN)6/2/224935-29%Hold
Ingles Markets (IMKTA)5/5/229589-7%Buy Half
Inspire Medical (INSP)10/4/1959193230%Buy
Procept BioRobotics (PRCT)3/3/22253123%Hold Half
Rani Therapeutics (RANI)10/7/211712-30%Buy Half
Repligen (RGEN)11/2/18 and 12/31/1859162173%Hold
Sprout Social (SPT)9/3/20365243%Hold Half
TransMedics Group (TMDX)7/7/223432-5%Buy Half
Xometry (XMTR)1/6/225333-37%Hold