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Small-Cap Confidential
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July 21, 2022

This is the million-dollar question: With incoming data anything but straightforward the Fed is trying to thread the needle ever so gently to guide the economy down to a soft landing.

The Fed is Set To Hike Next Week. Then What?
This is the million-dollar question: With incoming data anything but straightforward the Fed is trying to thread the needle ever so gently to guide the economy down to a soft landing.

Given massive market implications as a result of its actions, let’s get into the weeds of the Federal Open Market Committee (FOMC) workings for a minute and talk about what they’re expected to do.

It’s more likely than not that the Fed will hike rates by 75bps (basis points) next week. This is what the market is pricing in with 69% probability, according to the CME’s FedWatch Tool. A 75bps hike implies a target rate of 225-250bps (i.e. 2.25% to 2.5%) after next week’s meeting, as per the chart below.


While there was talk of a 100bps hike last week – after the hot CPI data rolled in we briefly saw an 80% chance of a 100bps hike (see green highlight in the table above) – that magnitude of a move is pretty much off the table now.

It would be a little crazy for the Fed to surprise to the upside in the current environment, especially given that two new additions to the FOMC (Susan Collins and Michael Barr) that ever so slightly tilt the balance toward the dovish end of the spectrum, at least in the short-term.

The bottom line is the market appears comfortable with a 75bps hike next week. After that there’s no meeting in August, then the FOMC is back at it in September.

If we pan out and look at the dot plot, which shows FOMC participants’ assessment of the “right” rate in the future, we see that the median projection for 2022 is about 3.35%, slightly lower than the implied year-end rate of just over 3.5% (indicated by the red dot).


The implied cadence here is that the Fed hikes another 75bps (or maybe 50bps) in September taking the target rate up to 300 – 325bps, then makes smaller hikes of around 25bps in November and/or December.

Looking out into 2023 the median projection is just a fraction higher at around 3.65%, but the market is actually expecting the Fed to cut. See how the red dot is at about 3.15%?

Then we go down again in 2024 and over the long-term.

What do all these dots tell us?

One interpretation is the market sees a looming recession and a Fed that needs to slash rates. Or, a scenario in which inflation does come back in and higher rates aren’t needed. Or some combination of the two.

Not mentioned yet but another major factor is the Fed’s handling of the balance sheet. It aims to trim it and that will influence rates as well. Right now it is slashing Treasury and agency-backed securities at a rate of $30 billion and $17.5 billion a month, respectively. And those amounts are set to double in September.

If your eyes haven’t rolled over into the back of your head yet (mine have) then consider this – if the Fed is able to engineer the so-called soft landing and we get no recession (or a very mild one), inflation comes down and the 10-year yield sticks at around 3% (give or take) then there is absolutely room for the market to rip higher, probably led by growth and small-cap stocks.

I’m not saying this is going to happen, just that it is a possible scenario. We’ve seen the market open up to this possibility this week.

These are the types of stocks that have been hurt the most because of “runaway” inflation and rate-hike shocks. It’s almost always the worst-performing groups that bounce back the most when the market turns up after a correction.

One area of high growth, software stocks are trading below their five-year trailing averages (using enterprise-value to forward revenue multiples), and roughly around their previous five-year (i.e. five - 10 years ago) trailing average. There are ways to slice and dice that data (i.e. new IPOs in the mix or not, higher growth groups vs. lower growth groups, etc.) but big picture, these stocks are no longer expensive.

Also, as I’ve said several times in recent weeks small-cap stocks are trading at a discount, and have been for a long time. The S&P 600 Small Cap Index’s forward P/E (yes, a function of forward estimates that are probably still too high, but still) sits at around 11.8 now.

Last time it was below 14 was during the Covid-induced market crash. And before that it’s typically only that cheap during recessions. This can be seen in the chart below, courtesy of Yardeni Research.


To wrap things up, does this mean we should all go out and load up on growth and small-cap stocks right now?

Not exactly, but an incremental increase in exposure probably makes sense—especially if you can stomach the volatility that’s likely in the coming months.

The market upside scenario essentially hinges on the Fed successfully threading the aforementioned needle and taming inflation without totally crushing growth. And there are, of course, a wide range of outcomes, degrees of success/failure and curve ball scenarios too (war, pandemics, etc., etc.).

Plus, we’re in earnings season, which is always a crazy time.

But at the end of the day it seems the market is interpreting the incoming data as a “bad to better” situation, and that’s typically good for stocks.

Should that continue it’s probably a good idea to ramp up exposure, gradually.

If the data turns more dour and the Fed begins to signal a higher for longer rate hike cadence and/or inflation persists and/or a deeper recession scenario jumps on the table, it will be time to begin to trim exposure again.

Let’s hope that doesn’t happen.

Recent Changes

Avalara (AVLR) continues to climb out of the gutter along with other beaten-down software stocks. There’s no news and earnings come out on August 8. Analysts are looking for Q2 revenue to be up 24% to $209.2 million and adjusted EPS of -$0.07. We’d like management to guide toward full-year revenue of at least $870 million (+24%) and EPS of -$0.06 or better. HOLD A QUARTER
Earnings Date: Monday, August 8

CS DISCO (LAW) reports Q2 earnings on August 11. We’re looking for Q2 revenue of $33.4 million (+13%) and EPS of -$0.27. We want management to guide for 2022 revenue of at least $150 million (+31%) and EPS of -$0.82 or better. With a consumption-based pricing model there’s room for some variability in the company’s growth. HOLD A HALF
Earnings Date: Thursday, August 11

DigitalOcean Holdings (DOCN) received a couple of black eyes last week as both Morgan Stanley and Goldman slashed price targets, citing risk of slowing software spending heading into a recession and, more specific to DOCN, the company’s consumption-based pricing model. Earnings will be reported on Monday, August 8. Analysts are looking for Q2 revenue of $134.6 million (+21%) and EPS of $0.10. We’d like 2022 guidance to come in ahead of $570 million (+36%) with EPS at $0.66 or better. We started with a half position and I’m holding steady with that exposure given that the company will need to beat expectations and/or guide for a very strong back half of the year to meet full-year expectations. HOLD A HALF
Earnings Date: Monday, August 8

Ingles Market (IMKTA) is chugging along, not drawing too much attention to itself. That’s fine by me. We just received a dividend and the stock has traded consistently higher over the last two weeks. Consensus estimates are useless here. They’re calling for revenue to dip 9% this year to $4.56 billion and for EPS to fall 60% to $5.10. But through the first half of the year revenue is up 16.6% to $2.77 billion and EPS is $7.10. Unless tellers start handing out hundred dollar bills to customers we should be just fine. BUY A HALF

Inspire Medical Systems (INSP) has been performing well since I moved back to buy several weeks ago. There’s been no news since the FDA approved more MRI scan conditions (like full body) for patients with Inspire devices implanted. This approval is retroactive, which means patients with devices in place since 2018 are good to go. In Q2 analysts see revenue up 48% to $78.4 million and EPS of -$0.61. Full-year revenue should climb by 46% (hopefully more) to $340 million while EPS will probably be around -$2.02. BUY
Earnings Date: Tuesday, August 2

Procept BioRobotics (PRCT) caught Keybanc’s eye this week as they slapped a 47 price target on the stock (closed at 36 yesterday). Beyond that there’s no news, except an earnings date of August 4. What’s the hurdle? We need Q2 revenue of $14.4 million (+70%) and EPS of -$0.48. Guidance for 2022 needs to be $60 million or better (+74%) with EPS of -$1.82, at least. Remember this is a new-to-the market story. Revenue in 2020 was $7.7 million, ramping up to $34.5 million last year (+347%). Averaged out 2022 and 2023 should be roughly 80% growth each, meaning $110 million by the end of 2023. In short, it’s supernatural growth. HOLD HALF
Earnings Date: Thursday, August 4

Rani Therapeutics (RANI) is a pre-revenue story so earnings (date not yet announced) is more about updates on the pipeline. In the second half of the year we should get an update on the Phase 1 clinical trial of RT-102 (treatment of osteoporosis) and also see a second Phase 1 clinical trial start. Management should also provide incremental updates on RaniPill HC (high capacity). With the standard RaniPill and the HC version the company expands the number of potential applications, including larger biologics such as Cosentyx, Keytruda, Herceptin and more. Rani has $107.8 million in cash, which should get it through the end of 2023. BUY A HALF

Repligen (RGEN) gives us the scoop on Q2 results on August 2. UBS just initiated with a 213 price target. In Q2 we’re looking for revenue of $189.6 million (+16%) and EPS of $0.72. Full-year revenue should be up at least 18% to $790 million while EPS needs to be at $3.09 or more. The stock is pushing up against overhead resistance at 175 again. A move through that might trigger an upgrade to buy. However, the more conservative move is to wait until after earnings are reported and see how foreign exchange is affecting things. Recall last week I stated 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 now. The company also disclosed that 27% of costs were denominated in foreign currencies (i.e. there could be some savings there). HOLD
Earnings Date: Tuesday, August 2

Sprout Social (SPT) will report on Tuesday, August 2. Look for revenue of $60.3 million (+23%) and EPS of -$0.06. Full-year revenue should be up 36% to $250 million while EPS comes in near -$0.12. No news. HOLD HALF
Earnings Date: Monday, August 8

TransMedics Group (TMDX) reports on August 1. Our newest addition is addressing an unmet need in the organ transplant market. Its technology – the Organ Care System (OCS) – replaces the old standard of care, cold storage. 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%). This is another early-stage commercial launch story so execution is crucial for the stock to keep working. The risks are also higher at this stage of the game because it’s easier for management, sales, marketing, etc., teams to slip up. BUY A HALF
Earnings Date: Monday, August 1

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 Q2 revenue is seen growing 84% to $93.1 million while EPS should be around -$0.32. Full-year revenue should be up 83% to $400 million while EPS should be around -$1.05. HOLD
Earnings Date: Wednesday, August 10

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 7/21/22ProfitRating
Avalara (AVLR)2/1/194091128%Hold Quarter
CS Disco (LAW)9/2/215725-56%Hold Half
DigitalOcean Holdings (DOCN)6/2/224942-14%Hold
Ingles Markets (IMKTA)5/5/229593-2%Buy Half
Inspire Medical (INSP)10/4/1959206251%Buy
Procept BioRobotics (PRCT)3/3/22253643%Hold Half
Rani Therapeutics (RANI)10/7/211712-29%Buy Half
Repligen (RGEN)11/2/18 and 12/31/1859196232%Hold
Sprout Social (SPT)9/3/20365962%Hold Half
TransMedics Group (TMDX)7/7/2234340%Buy Half
Xometry (XMTR)1/6/225339-26%Hold