In Cabot Small-Cap Confidential, we’ve been riding the strength in two growth-oriented areas of the market—cloud-based software and medical devices—for a while. Our exposure to small-cap stocks in these sectors is helping power gains like 106%, 112%, 70% and 61%, with an average holding period of just over a year! I expect the positive momentum in these two small-cap sectors to continue in 2018.
Here’s why, along with a positive outlook on a third sector that should deliver profits to small cap investors in the year ahead.
3 Small-Cap Sectors for 2018
Small-Cap Sector #1: Subscription-Based Software Stocks (i.e., Cloud Software Stocks)
Software stocks have been on a roll, averaging annual gains of around 24% since 2010, versus 12% annual gains for the broad market. We’ve been riding the wave in Cabot Small-Cap Confidential, jumping on cloud-based small-cap software stocks that screen well for revenue growth, transitioning to positive earnings, acquisition potential and market expansion.
[text_ad]
Two of the big-picture trends powering cloud software adoption are (1) nearly all companies are becoming digital enterprises and embracing cloud-based initiatives and (2) established software companies are moving to cloud computing and subscription-based pricing models (newer companies are simply starting out this way). Soon, we’ll be at a point where we’ll drop the term “cloud-based software” because almost all software will be delivered to the cloud, and on-premise software will be the delivery model requiring an introduction.
The above factors are helping drive consistent revenue and earnings growth in software stocks. Remember when the profit potential of these stocks was all about what they might be able to deliver in earnings down the road? We’re arriving at that destination. Now that the subscription-based pricing model is maturing and there’s better alignment of revenue and expense recognition, there are more examples of profitable companies employing it than there were years ago. This should help increase investor confidence in relatively young subscription software stocks (i.e., small caps) that hold the promise of fat profit margins but still have a way to go to get there.
Finally, smaller software stocks have become increasingly attractive acquisition targets. The new tax law will allow U.S. companies to repatriate offshore assets back to the U.S. at no extra cost (after they pay an 8% tax on assets in real estate and other hard assets, and 15.5% on cash, which is much lower than the prior rate of 35.5%). To put things in perspective, Credit Suisse reports that Microsoft, Oracle, Google, IBM, Adobe, Salesforce.com, Cisco and CA Technologies collectively have over $300 billion in overseas assets. All the software stocks I cover could be bought for less than this amount!
In short, software companies are growing due to a strong global economy, steady IT spending (up roughly 4% in 2017 and probably the same in 2018), greater adoption and confidence in the subscription-based pricing model, increased investor confidence in the delivery model and M&A potential. Given all this, it’s possible we’ll see double-digit returns for software stocks in 2018. And I think many small-cap cloud software stocks will do much better than that.
Small-Cap Sector #2: Medical Device Stocks
There are a lot of reasons to like medical device stocks. Utilization trends are up, global growth is good, revenue and EPS for many stocks is trending in the right direction, and according to Morgan Stanley, device pricing has declined 25% to 30% relative to drugs (up 80%) over the last seven years. Throw in medical device segment valuations that are roughly in-line with the S&P 500 versus a significant premium a year and a half ago, and the picture gets even better.
There is one potential negative that’s been on my radar however, but the risk has been mitigated, for now. And this should help small-cap medical device stocks in the year ahead.
The risk was that the medical device tax could go back into effect. The short version of this story is that a 2.3% tax on medical devices was passed as part of the Affordable Care Act. Implementation has been delayed, but was set to go into effect in 2018 unless the U.S. House and Senate voted to extend the tax holiday. They didn’t get the job done when they passed the Tax Cuts and Jobs Act. Companies were literally days away from cutting checks to the IRS.
But on Monday January 22, President Trump signed a stopgap spending deal that delays the 2.3% tax for another two years (retroactively, beginning on December 31, 2017). While this doesn’t officially repeal the tax, it kicks the can down the road for another two years and gives lawmakers time to officially kill the tax before it ever goes into effect.
Small-Cap Sector #3: Biotechnology Stocks
Biotech is back, baby!
In 2011, a historic biotech run began with a 22% gain. The sector was then up 38% in 2012, 74% in 2013, 33% in 2014 and 12% in 2015. That stretch of performance made biotech the only sector to outperform the market for five consecutive years!
Then biotech stocks did what they always do—they offered a sharp reminder of the risks investors take on when putting money into drug development. Biotech stocks cratered. Between mid-2015 and early-2016, biotech stocks retreated almost 40% from their highs.
Most of 2016 was spent regrouping. And then in early 2017, a more stable (relatively speaking) uptrend began to take shape. Since the beginning of last year, biotech stocks are up 28%.
Why the strength?
Part of the reason is that new (and some potentially revolutionary) drugs have been hitting the market. And there have been numerous clinical breakthroughs that should lead to more new product launches, including first-generation immune-oncology drugs and blockbuster rare-disease therapies. There’s also a movement to help accelerate approval of important new medicines. And it’s possible many biotech stocks were just beaten down so much that they began to look like relative values in a market where almost everything else has gone up!
Now, larger drug makers appear to see value in smaller biotech stocks. They are, arguably, the ones best positioned to make a call on value. And investors are getting the message. The Wall Street Journal recently reported that, so far in 2018, the median premium paid in healthcare deals worth over $1 billion is 89%. That’s almost twice the median of 45% since 2010.
Recently we’ve seen Sanofi (SNY) snap up Bioverativ (BIVV), Celgene (CELG) buy Juno Therapeutics (JUNO) and privately-held Impact Medicines, Gilead Sciences (GILD) take out Kite Pharma (KITE), Takeda (TKPYY) buy TiGenix (TIG) and Roche (RHHBY) acquire Ignyta (RXDX).
In short, a number of positive factors are helping investors get over the concerns of drug pricing that helped scuttle the biotech rally two years ago. And while the sector will never be a sanctuary for the faint of heart, risk-tolerant investors are likely to keep finding profit opportunities in biotech in 2018.
In Cabot Small-Cap Confidential, we currently have 10 positions with exposure to these three three small-cap sectors. And I expect to add more in the year ahead. To find out what stocks are helping us beat our benchmark by over 23% and get my full 2018 Small-Cap Outlook, grab a subscription today. Just click here to get started.
[author_ad]
