This webinar was recorded on February 13, 2019
You can download the slides here
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The downdrafts that ended 2018 created some small-cap bargains.
Over the past 80 years, small caps have outperformed other sectors by a substantial margin.
Small-cap expert Tyler Laundon discusses the rewards of having small caps in your portfolio. He talks about what went right, and not-so-right, in 2018 and says what to expect in 2019. He follows that with a discussion of two particularly promising small-cap sectors he’s following closely. He conclude with his secret stock picks.
This free webinar is moderated by award-winning writer and analyst Chris Preston, Chief Analyst of Cabot Wealth Daily.
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WEBINAR TRANSCRIPT:
[00:16:53] I tend to focus a lot on technology and within tech, cloud software has been a trend that we’ve been following for a number of year in the small cap portfolio basically because it is, in my mind, the biggest tech story out there -- everybody is doing it.
[00:17:10] We’ve been doing it for a while but really we’re seeing the positive impact of this transition to the cloud. Really across the world. Without going into too much detail, there are really three buckets.
[00:17:43] There is infrastructure, platform, and software and as small cap investors we are mostly focused on software and platform because when you get into infrastructure you’re talking about the pipes and the backbone of the cloud. And those are the really big companies like Amazon and Microsoft. Most small cap companies don’t have scale to be big infrastructure plays.
[00:18:10] We’re talking about the software stocks platform stocks that make the applications that people interact with on their computers, mobile devices, tablets whatever.
[00:18:24] So big picture the global trend is toward digital economies. That seems like a strong trend. It’s been going for years and there’s a lot of investment in that. CIOs, Chief Technology Officer, Information Officers are prioritizing investments in the cloud in security around the cloud in compliance. There’s a lot of dollars being spent and a lot of dollars being earmarked for future investments in these priorities.
[00:18:57] We can gain exposure to those through specific stocks that have products in very very specific markets (more on that in a moment). We can also have limited exposure to trade. So if that’s a concern the average software stock generates less than 25 percent of revenue from outside of the United States.
[00:19:23] Obviously there are certain stocks that that are well above that threshold but there’s also a lot especially for small caps and software stocks that have zero international exposure. Analysts are generally looking for around 5.2% growth in software spending this year. That’s down a little bit from 2018 but definitely a very strong demand environment.
[00:19:52] And when we look at the group on an individual stock level we’re seeing that the fundamentals of small cap software stocks are improving as as the business model matures. It’s become a more durable and proven business model. Companies are gaining wider user bases that are more dependent on their software and that’s creating sticky products that are generating high recurring revenue.
[00:20:23] When we talk about recurring revenue we’re talking about subscribers that will pay for a product quarter after quarter and year in year out. And we’re not just talking about consumers it’s mostly business users that are buying the high value SaaS solutions.
[00:20:42] We also have a larger base of profitable small and mid-cap companies. When I was looking at these stocks three years ago a lot of them were not profitable. Now a lot of those ones that we were hoping would grow and gain scale and become profitable -- now they are. The downside is that there are now limited options of small cap cloud software stocks that are attractive to trade with market caps of under a billion. We have had to make some adjustments there. There still are some talk about a couple but for the most part we’re seeing stocks with market caps of over a billion now.
[00:21:24] Why invest now?
[00:21:28] If we can have some resolution with China there is potential for software stocks to expand into Asia if there is a trade deal that can be reached with IP protection. I’m not going to go into the weeds on this but it’s definitely a potential huge tailwind for the group, if that can happen. I don’t know what that looks like exactly but it’s something to pay attention to.
[00:21:55] We’ve also seen a significant pullback in software stocks in the trading multiples, which are now in line with their historical averages. So at the end of Q3 2018 they were pretty elevated, but are more in line now so that’s attractive.
[00:22:10] At the same time the strategic value of a lot of these companies has gone up. So an increase in deal flow over the last three years, and cloud is a strategic priority and a lot of companies are investing lots of money to snatch up some of the smaller pure play providers. We had one in small cap Aptio that was acquired a few months ago. Just one example.
[00:22:46] There’s been a lot of M&A activity which obviously helps with with quick gains.
[00:22:56] So what to look for in SaaS stocks. So exposure to secular growth trends and secular growth trends are generally trends that aren’t cyclical.
[00:23:08] We’re not looking for oil stocks here. We’re looking for stocks that have businesses that are not going to rise and fall that much based on what the global economy is doing. They’re really point solutions that should have relatively high demand.
[00:23:26] We’re looking for companies that have durable business models, high revenue and profit growth. If they’re not profitable at least they’re trending towards profits. We’re looking for a reasonable valuation relative to their peers and growth and some insulation from cyclical trends interest rates, trade, etc.
[00:23:45] No stock out there is going to check all these boxes but these are just the big picture things I try to keep in mind when selecting stocks for the small cap portfolio.
[00:24:02] Q2 holdings is in in my small cap portfolio, the only one that’s in the portfolio now that I’m talking about today.
[00:24:12] We got into Q2 when it was trading for around $24. It’s now at $64. Q2 holdings makes cloud they sell cloud based virtual banking software that they sell to small and mid-sized banks, credit unions.
[00:24:50] One of the pros -- the company is moving upmarket in the slightly larger companies and it’s a pretty good environment for banks to be investing in their platforms right now given that they have higher net interest margins with rising interest rates.
[00:25:04] On the downside we have seen some financial institution consolidation especially at the small end of the curve where Q2 plays. That’s something to watch out for. But the growth numbers are pretty solid -- revenue up hopefully 24% this year almost 30% next year. EPS growth in 2018 is massive just because they are coming off such a small base and at the moment 2019 doesn’t look like the big earnings growth year.
[00:25:44] Sharp Spring is a fairly speculative stock. The market cap is $125 million. They sell cloud based marketing automation software for small and mid-sized companies. So these are things like email delivery lead generation, blog builder, social media, customer response management software. You might recognize names like HubSpot. Salesforce obviously and then Marketo was acquired by Adobe. Those are the big the big competitors. Revenue growth is estimated to be up 49% this year. It’s not a profitable company.
[00:26:26] The one thing I will say about 2019 estimates is this is a microcap stock and I don’t know how valuable consensus estimates are or even if there really are any reliable ones out there. I wouldn’t focus too much on the estimated 2019 numbers. If if this stock looks interesting to you this is the kind of stock that you would invest a very small amount of money in at first and then build that position over time as confidence increases.
[00:26:55] Earnings are due out in March so that would be the time to really tune into that.
[00:27:01] Upland Software I have a little more confidence and I’ve been following it for a little while few years. $711 million market cap. They sell cloud based enterprise work management software that does things like plan and manage and execute on projects like IT and workflow digitization projects. They are led by a guy who was the CEO of Proficient and he has brought over an acquisition led growth strategy.
[00:27:31] You’re going to see little spikes in revenue growth depending on what their acquisitions were in the last year. In 2018 revenues should be up around 53% with really nice earnings for a relatively small company. $1.60 in EPS, up 17% in 2018. 2019 revenue up 27% with 24% earnings growth.
[00:28:17] Blackline sells cloud based finance and accounting software like financial close, account reconciliation, and controls assurance. A lot of the SEC filings that we look at are processed and put together using Blackline software so for large companies that are looking to automate and streamline operations and pull in vast amounts of data from Oracle and all the other databases that they have data sitting in, Black line can pull all that stuff in and really streamline that process for them. It’s really an efficiency and automation solution. Revenue growth is is quite attractive. 31% this year. 22% next year.
[00:29:18] It turned profitable in 2017 and should earn around 9 cents this year. A huge earnings growth rate at 800% but that’s just because it’s coming off such a small base. More normalized in 2019 -- 67% earnings growth.
[00:29:41] I put on my watch list a whole bunch of small cap software stocks that went public in 2018.
[00:29:52] Zora -- $2.2 billion market cap.
[00:29:56] EventBright. You might have interacted with them. They have a platform to play and promote and launch live events.
[00:30:02] SurveyMonkey. You’ve probably received this survey monkey survey before. They went public.
[00:30:10] Avalera. $2.9 billion market cap. They sell sales tax automation software. A lot of states are now implementing sales tax collection for online sales. You don’t have to have a brick and mortar location within a state to have to collect sales tax that came about because of the Supreme Court decision that overturned the precedent in the Wayfair case. That’s an attractive one for a niche market but sales tax automation isn’t something that’s going to go away. It’s only going to grow.
[00:30:59] Tenable is a cyber security company.
[00:31:08] The second area where we spend a lot of attention is health care and specifically medical technology. We do some biotech as well but mostly it’s medical tech.
[00:31:23] Medical technology in my view and most analysts out there is any technology that can be used in a care setting and or devices with which a patient can be diagnosed or treated. So it covers a lot of different things devices, implants, drug delivery systems, drug manufacturing equipment, data processing software, connected health IT, software for the life sciences industry. It doesn’t cover things like managed care. It’s not things like nurse staffing temporary nurse staffing. It’s really quite specific to these technologies, software devices, implants that kind of stuff.
[00:32:13] So why invest?
[00:32:15] As far as health care goes it’s relatively defensive yet high growth. The innovation and product development roadmap is more incremental than disruptive and you find disruptive more with biotech where suddenly you have a compound that can help with some serious ailment. Revenue goes through the roof when that product hits the market.
[00:32:43] With Medtech, it’s really more incremental. That means that we see more gradual value creation in these types of companies and the stock price appreciation is more gradual on the way up than with biotech.
[00:33:00] Again a general statement but we tend to see fewer stocks blow up in the MedTech space then in the biotech space, or implode. And for me I like to limit risk as much as possible while trying to capture as much upside as possible so Medtech fits pretty well. And attractive M&A potential.
[00:33:26] So a couple secular trends that have been featured a lot in the media that I can kind of identify with that I think you can too for Medtech is consumerism. We are all becoming more a part of the decision making and care process for ourselves and our loved ones. We also have more control over how and where our health care dollars are being spent. That is one of the big picture trends it’s feeding into Medtech.
[00:33:53] We’re also seeing personalized health care and personalized medicine in terms of gene research data analytics customized prevention, diagnosis, treatment and drug dosing programs. Healthcare is increasingly based on individual biochemical makeup and that all of course came about through gene mapping. The idea is that with Medtech you can invest in the building blocks of a better health care system. And there are lots of small cap stocks that are involved in this space that have really innovative and exciting technologies that they can do great things with on their own or they can join up with a larger med tech company such as Boston Scientific or Edwards and still deliver those products to the market.
[00:35:36] Moving on to some med tech stocks:.
[00:35:39] Biotelemetry has a big profile out there even though it’s a small company. $2.5 Billion market cap.
[00:35:49] They have three businesses. They make and sell devices and also sell monitoring services and lab services for clinical research. The biggest chunk of revenue comes from body-worn, remote cardiac monitoring devices and remote blood glucose monitors. Most of their business is the cardiac monitoring. They have Holter, extended wear and other types and they also have designed the platform that’s behind the Apple heart study. So for people that are using the Apple Watch and following their heart rates with that Biotelemetry is the hidden technology behind that.
[00:36:35] Revenue in 2018 was quite high because of an acquisition of LlifeWatch AG, a European based company. It was their biggest competitor that they purchased so that really helped on the top line. In 2019 in revenue, we’re looking for a 10% growth with no EPS growth. But again we’re coming off of a big 2018 with the major acquisition. Obviously demand for the stock is relatively high.
[00:37:26] Tactile Medical. The market cap is $1.3 billion. They make pneumatic pump devices to manage lymphedema at home. Lymphedema affects more than 5 million people in the US. and more and more people are becoming aware of it. The market seems to be growing by about 20% a year. Tactile Medical does a lot of business with Veteran Affairs hospitals.
[00:38:00] Basically their devices help drain lymph fluid resulting from surgery infection or other types of trauma. They let people stay in their home or go to work and are designed to allow people enjoy freedom and to be cared for outside of the clinical setting. Revenue up 28% last year. 21% percent in 2019. It is a profitable company and revenue growth accelerating to 17% and 2019.
[00:38:55] Innogen is an interesting one. It’s actually a larger company than I typically cover but I started following it when it was much smaller so I have always remained interested in it. The market cap right now is just under $3 billion.
[00:39:09] I t used to be a $280 stock now trading at around $138. It has not taken back off yet but it’s one to watch because Innogen was the first mover in the compact and lightweight portable oxygen concentrator market. Innogen came out with much smaller tanks that could fit in a normal sized bag which would allow people to you know basically be mobile. Significant market size even with declining rates of smoking.
[00:39:53] What is most interesting about Innogen is JP Morgan named it as one of their top small cap stocks for 2019. So keep an eye on Innogen. Earnings are coming out on February 26. We’re looking for around 40%t revenue growth this year and 26% next year with modest earnings growth next year.
[00:41:15] And then other medical technology stocks in no particular order:
[00:41:19] Inspire Medical Systems neuro stimulation solution to treat sleep apnea.
[00:41:26] Glaucose, which Mike Cintolo has covered in Cabot Top Ten Trader, makes injectable stents for glaucoma and they’ve just put out a new and improved version of their first solution. So Glaucose is an interesting one to watch.
[00:41:42] Nevro spinal cord stimulation systems for chronic leg and back pain.
[00:41:47] Intersect drug delivery for ear nose throat physicians.
[00:48:15] Questions and Answers.
[00:48:15] What are the absolute performance indicators that you look for in a small cap equity?
[00:48:30] I’ll go through a whole bunch of stocks every month of new stocks off screen for a bunch of stuff and then I’ll pull those over, create my watch lists, and then I’ll go down through. The first the secondary screen really isn’t fundamental. It’s just do I understand what their target market is and what the business is and what are they doing. If I like that it goes on to the next bucket. Then I’m really looking for revenue growth and earnings growth, ideally both trending in the right direction. I will let a company in that’s had a quarter or a year of decelerating growth if there’s a good reason like an acquisition that made year over year comparison hard to hard to surpass.
[00:49:22] A t a high level revenue and earnings growth or at least trending in the right direction. With some sight towards profitability.
[00:49:43] We’re looking at high growth software and technology stocks that really shouldn’t have much if any debt. So that’s that’s the next step.
[00:49:53] Then I go deeper down into the weeds where we look at things on a product level. That’s all the research that I put in the Cabot Small-Cap Confidential issues. Go through the whole product lineup. What the what the technology is. What the risks are. All that kind of stuff. That’s really the process.
[00:50:19] It starts with big picture. Do I understand a company revenue growth earnings growth. Make sure there’s no red flags in debt or ownership structure and then get into the weeds a little bit more.
[00:50:35] Are you concerned about the relatively low trading volume for most of the stocks you mentioned?
[00:50:43] As a general rule no because it’s all relative to the number of shares that are outstanding. So it’s hard to it’s hard to talk about it without looking at a specific example.
[00:51:00] For all of the stocks that I formally recommend I do write up a section in the report on trading volume and make sure there is no red flag.
[00:51:18] For a lot of the companies that we’re recommending if it has a market cap of two billion dollars it’s it’s trading volume is just by nature of the size of the company on dollar terms is not going to be that significant.
[00:51:33] One thing I will say is that a lot of these are youngish companies and in particular ones that have just recently gone public within the last six months or a year, you will see early investors holding onto some shares after the company has gone public. There might be a lot of shares that are owned but aren’t publicly traded until those early shareholders release those shares for the public market. I do like to see an increase in trading volume over time especially as it relates to an increase in the share count from early investors putting more shares in the market.
[00:52:29] l have to be clear I’m not talking about companies that are issuing secondary stock which is a whole different thing. The point being relatively low trading volume, so long as it’s in line with the size of the company and the number of shares outstanding, is not a red flag but I go through all that when I’m looking at the ownership structure.
[00:53:03] What level of debt are you comfortable taking compared as compared to cash flows?
[00:53:21] That that’s one of those fundamental analysis metrics that I actually don’t have to use that much because most of the companies that I’m fine don’t have any debt. So I don’t I don’t have a hurdle.
[00:53:39] That’s the short answer. I will say that when we have a company that has debt or that it is issuing convertible or something like that obviously we we look at that. We study it, we write it up, and we talk about it relative to that specific company. If there is a company that has debt from some event in the past -- maybe an acquisition or maybe they’re owned by a private equity company -- and they were levered up and they’re going to have to unload that by issuing new stock down the road you can wrap your mind around that when you look at that particular company.
[00:54:19] To summarize, I don’t have a general threshold because it’s really so company specific. And most of the companies that I’m looking at really don’t have significant or any debt I think we have time for a couple more questions.
[00:54:37] Are there any international small cap stocks that you like?
[00:54:49] One that I had my eye on is Mix Telematics which sells telematics solutions like tracking software, fleet and mobile asset management software. It is based in South Africa and has branched out around the rest of the world. The CEO is based in the US but they report in the rand. It’s an interesting company.
[00:55:45] The growth has been pretty stable and it is profitable. It hasn’t really managed to break out, like a breakout above 19 or. Holding on to that would be definitely a good sign.
[00:56:22] Talend Software is another. The stock’s kind of in the doldrums right now. They’re a France-based integration solution for big data. I could see them being a potential acquisition target. I didn’t really follow the news release for why the stocks fell so much last November. But I think that’s one to watch especially what we’ve seen a lot with these stocks that have really tanked in Q4 and then have international exposure is they started to come back a little bit. And then on a good earnings report they pop -- a little bit of a relief rally. When you see that that’s your signal to dig a little deeper into the story and then decide whether to make an investment or not. Those would be to Talend and Mix Telematics for like really high levels of international revenue OK.
[00:57:44] What are your thoughts on Cutara?
[00:58:16] Cutara develops laser and light based systems for minimally invasive aesthetic procedures.
[00:58:37] Basically it’s cosmetic surgery -- products you use, pulse light, laser applications or both. Combined with control system software for hair removal or wrinkle, pore reduction, resurfacing, and treatment of skin texture. Market cap is quite small. $217 million. I don’t know the whole story but obviously there is something going on at a fundamental level that appears to be bigger than an acquisition result in year over year tough comparable.