May 26, 2022

Seeking “Clear and Convincing” Data
After a rough week last week small caps have bounced back over the last two sessions and have the potential to close at a three-week high today. I’d like to see the S&P 600 Index close back above 1230 (at 1224 now) before turning more bullish.

If we’re being technical … small caps are in a bear market. Yes, the index is “only” 17% off the high as of mid-day Thursday. But it crossed the -20% threshold earlier in the month (was down 23%) and was down just over 20% early this week.

This performance is slightly worse than that of the S&P 500 Index, which is 16% below its high. But small caps are faring far better than the Nasdaq, which is currently 27% off its high.

What about small-cap stock valuations?

Believe it or not analysts have been bumping up forward earnings estimates for both large and small caps.

Both are now at record highs. Forward earnings for small caps rose for the ninth time in ten weeks!

As of this reading, analysts see small cap earnings up 13.7% in 2022 and up 11.4% in 2023. Both growth rates compare favorably to estimated large cap earnings (+10% this year and next).

Are analysts smoking something?

You’d think with everything going on in the market and around the world that they’d be slashing forward estimates. But they’re not (yet, at least).

The impact on rising forward estimates and plunging stock prices combines to put considerable downward pressure on small-cap valuations.

As of the beginning of this week the S&P 600 SmallCap Index is trading with a forward PE of just 11.7. That’s very inexpensive relative to history, as this chart from Yardeni Research shows (S&P 600 PE is the green line).

Not only are small caps cheap, but they’ve been that way for a while, especially relative to large caps. That’s rare, as the asset class tends to trade at a premium (see how the green line in the chart above is typically above the red and blue lines).

Small caps have now traded at a discount to large caps for 92 weeks. They haven’t traded at a discount for that long since 1999 – 2002.

Moreover, the nearly 30% discount is about on par with the largest valuation discount since 2001.

As an asset class, small caps look “attractive.” And for those looking to add exposure in a long-term-oriented account (IRA, etc.) it’s probably a good time to be adding shares of an index ETF.

On a stock-specific level, things are still very muddled. While we continue to be overdue for some sort of relief rally, we have a number of things on the economic calendar in the next two months that will likely determine how the second half of 2022 goes.

While economic data isn’t always the most exciting thing to follow, the Fed is telling us it matters more than normal now, so we’d be silly not to pay attention.

On that note ... here’s what’s coming up, what’s expected and why it matters.

Today we received the second estimate of Q1 GDP. The first estimate from April 28 was that GDP fell 1.4%. Today’s update says it fell by 1.5%.

The first estimate of Q2 GDP doesn’t come out until July 28. Current projections are that Q2 GDP will rise by 1.8% (latest GDPNow data from yesterday). However, that growth rate estimate declined from 2.4% on May 18. If Q2 GDP were to be negative we would be in a recession, so get out there this Memorial Day weekend and buy, buy, buy!

On June 1 (next Wednesday) the Fed begins the quantitative tightening (QT) process. The Fed will let $30 billion of Treasuries run off each month in June, July and August and do the same with $17.5 billion of agency debt and mortgage-backed securities. Those amounts double starting in September. When it ends is undetermined.

On June 10 the BLS releases May Consumer Price Index (CPI) data. We would really, really like to see some easing in the inflation data.

June 14 - 15 the FOMC meets. A 50 bps hike is expected.

July 26 - 27 the FOMC meets. A 50 bps hike is expected.

In the wake of the Federal Reserve minutes from yesterday there has been more chatter about how the Fed’s path after July will likely be more dependent on data releases than a set path.

That makes sense considering that between now and the end of July we’ll have two months of QT, have received a first estimate of Q2 GDP, will have May CPI data and (assuming two 50bps hikes) the Fed Funds target rate will be at around 2% (market pricing implies Fed policy rate around 2.5% - 2.75% by end of year, could easily be higher).

Tomorrow is going to be interesting as Fridays have typically been volatile lately, and we’re heading into a three-day weekend. There will be a lot of headlines about QE tightening after Memorial Day!

We’ll continue to take it as it comes. On a stock-specific level I’m seeing a lot of potential opportunities to buy beaten-up stories at what seem like terrific prices. We’ll be taking a swing at something next week when the next Issue of Cabot Small-Cap Confidential comes out.

Recent Changes
None

Updates
Avalara (AVLR) is essentially unchanged over the last week. It hasn’t gotten too caught up in the broader market’s gyrations since management reported earnings earlier this month. That’s encouraging, as is the EV/Forward Revenue multiple of 7. HOLD Quarter Position

CS DISCO (LAW) is up a couple points over the last week. As with AVLR, this is encouraging. If we can string together a few weeks of stability that would be a win. Software stocks are trading below five-year trailing average multiples and that implies some very good deals are out there. I think LAW could prove to be one for those that can be patient. EV/Forward Revenue multiple of 7.3 is attractive. BUY

Ingles Market (IMKTA) is our North Carolina grocery chain and, not surprisingly, shares have begun to recover from the May 18 decline, which was a sympathy move due to the drops in WMT and TGT. Ingles sells groceries and non-food items across a wide array of categories, but it’s not selling all the SKUs that a mega-retailer does. We’re talking typical grocery store stuff here, plus gas and pharmacy items. BUY A HALF

Inspire Medical Systems (INSP) is gearing up for SLEEP 2022, an annual conference held in Charlotte, NC where industry professionals, doctors, etc. gather. Inspire will introduce Inspire SleepSync, a digital platform that unlocks remote therapeutic monitoring through a Bluetooth-enabled patient remote and web-based patient management portal. We’ve seen INSP hold up well over the past week and stay above 150, a requirement for me to move back to buy. If it looks good in another week INSP may get an upgrade. HOLD

Procept BioRobotics (PRCT) continues to act very well and came within pennies of hitting a 2022 high yesterday. There’s no new news, just likely that decent resilience among MedTech players and a good company-specific story and trends with Procept are helping shares. HOLD HALF

Rani Therapeutics (RANI) is doing very little and there’s been no news since the Q1 update a few weeks ago. The Phase 1 clinical trial of RT-102 for treatment of osteoporosis is ongoing and we should get an update in the second half of the year. We should also see a second Phase 1 clinical trial start in the second half of 2022. Rani has $107.8 million in cash, which should get it through the end of 2023. BUY HALF

Revolve (RVLV) took another hit on Tuesday when a number of retail and social stocks sold off following Snap’s (SNAP) rough earnings report (and market reaction). While details matter, it may be that lots of bad news is already priced into retails stocks. After an ugly open yesterday, we saw Dicks (DKS) and Academy Sports & Outdoor (ASO) rebound throughout the day. And the selloff in WMT and TGT hasn’t turned into a slide – both seem to be drawing in buyers (for now). Recall last week the notes I shared from an investor meeting with Bank of America and Revolve management. The gist is that Revolve is saying sales are ticking up, as is frequency of purchase per customer. Full-price selling remains in the record-high 80% range. It should come as no surprise that more affluent consumers have an easier time absorbing higher food and energy costs, and maybe there will be a breaking point for them. But it doesn’t sound like we’re there yet. HOLD

Repligen (RGEN) is up modestly from its lows from last week (it had hit 140 for the second time after previously touching that level on April 26). Suffice to say, holding that line is important as we look for RGEN to build a base off which it can climb. HOLD
Earnings: Done

Silvergate Capital (SI) was sold before the stock dove a few weeks ago. SOLD

Sprout Social (SPT) had a tough day Tuesday (thanks SNAP) as shares closed down 16% on the day. But they never broke below support near 38.4 and SPT gained 8% yesterday, so things haven’t really deteriorated here (thought it was a close call and we’re not out of the woods just yet). This morning the company announced Sprout has joined the TikTok Marketing Partner Program and is launching integrations that give Sprout users tools around video scheduling and comment management. HOLD HALF

Xometry (XMTR) trades with an EV/Forward multiple of 3.5, which is very inexpensive. The stock is up modestly over the last week, but the trend remains down (XMTR below both 50 and 200-day moving average lines). Holding on because I think XMTR could be a winner when this market turns around. Management spoke at the JP Morgan Global Tech, Media and Communications Conference on May 23. HOLD
Earnings: Done

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