Markets After a long string of winning weeks for North American Equity markets it’s not too unexpected to see a bit of pullback in stocks. The major indexes have been on a tear over the past 2 months and it’s good to see equities let off a little steam. The Dow was lower this week by 0.6%, Nasdaq ended the week down 3.2%, and the TSX fell a slight 0.1%. | | | I love following the CNN Fear and Greed index. It’s helpful to get a sense of short term investor sentiment and, in my experience, has an uncanny reverse correlation with shorter term market peaks and troughs. And as Warren Buffett says ”Be fearful when others are greedy, and greedy when others are fearful…” Financials Things rarely go straight up or straight down. Interest rates have been dropping for the past 2 months but slightly stronger than expected US economic data may have put a short term bottom in treasuries and some interest rates. Investors are now thinking that interest rate cuts may be a bit further away than expected. I expect this thinking to stick around for a bit and may be just what the markets need to cool themselves off for a while. The US 10 year treasury bond yield popped back above 4% for the first time in about 3 weeks. | | Better than expected data and higher rates were bullish for the US dollar and with that it helped push down some US dollar priced commodities. | | And where US rates go so goes Canadian rates, even though economic data seems to be showing more weakness than in the US. | | Major Canadian banks and mortgage lenders continue to drop mortgage rates in Canada which are buoying housing and construction related stocks. "Five-year fixed rates are dropping and variable-rate mortgages will soon follow, experts predict.” Toronto Star | | Commodities A stronger US dollar over the past week has put a price lid on many commodities. Oil however, after having been in a sizable downturn, seems to have found a bottom, at least for now. The $70 level for WTI crude has acted as a floor and prices seem to have stabilised for the time being. It’s hard to think that with the current geopolitical and tensions in the Middle East that oil is still hovering near the lows for the past year. Are geopolitical tensions properly priced into energy prices and if so, what would happen to prices if we didn’t have the current hostilities in two major energy producing/transportation areas? Is it an indication of a slowing world economy? And what if the US strategic petroleum reserve wasn’t in the market buying back oil, and with US production still climbing, where would prices drift to? I can see the current bear case for oil but who’s brave enough to play that game right now, certainly not me. | | Natural gas prices are still being weighed down by milder than usual winter weather in North America. | | According to Baker Hughes drill rig activity is still below typical levels at this time of year even though we saw a sharp spike in Canada related to improving (freezing) weather conditions. There was a drop of one active rig in the US and an increase of 39 drill rigs active in Canada. Gold saw a healthy pullback this past week in line with some strength in the US dollar and higher rates. The chart for gold still looks very constructive and as I expect rates to re-establish their downward trend at some point gold likely is in a potential buying dip right now. | | Stocks We’ve had a pretty nice run in stocks over the past 2 months and I’ve been calling for a bit of a pullback for a couple of weeks now. This past week’s retracement seems overdue and likely will continue a bit further. Small stocks for a change have been outperforming larger stocks and value has outpaced growth. I think this general trend will continue and has the potential to be the dominant theme in 2024. The other theme that I expect to pick is smaller company takeovers. Lower cost of capital and general confidence coming back into capital markets, along with reasonable valuations should entice larger companies to lean more towards buying rather than building from scratch. What we are also keeping an eye out for is financings and maybe more IPO’s in 2024. The past 2 years have been some of the slowest in terms of small company financings and IPO’s and some industry players (accountants, lawyers, bankers) are starting to see an increase in enquiries and preparations from companies looking to tap the equity markets. A pick up in this activity will be a sign that capital is coming off the sidelines and more likely to start coming down market. Even though it was a quiet start to the year we did see some of our names make the new 52 week high list. Shares in ADF Group (DRX.T) continue to trade higher hitting another new 52 week high this past week. Other notable new 52 week highs include Foraco (FOR.T), Knight Therapeutics (GUD.T), Dynacor (DNG.T) and one of current favourites Thermal Energy (TMG.T). Shares in TMG.V reached 2.5 year highs on Friday. | | | | | | We’ve had a pop in some of our favourite names but are somewhat sitting on the fence right now waiting for some decent pullbacks before adding significantly to anything. The general market pullback that we are expecting should give us some better opportunities in some of our favourite names over the coming weeks. In the meantime we keep looking for new names that haven’t participated in this latest move in small stocks. Other Stuff I’ve got an interesting investing idea I wanted to talk a bit about this week. The company is called DIRTT Environmental Solutions. According to the company: “DIRTT is a leader in industrialized construction. DIRTT's system of physical products and digital tools empowers organizations, together with construction and design leaders, to build high-performing, adaptable, interior environments. Operating in the workplace, health care, education and public sector markets, DIRTT's system provides total design freedom, and greater certainty in cost, schedule and outcomes. DIRTT's interior construction solutions are designed to be highly flexible and adaptable, enabling organizations to easily reconfigure their spaces as their needs evolve. Headquartered in Calgary, Alta., Canada, DIRTT trades on the Toronto Stock Exchange under the symbol DRT.T.” This is not the typical profitable and growing microcap that we prefer. This one is a turnaround story. The company has been struggling in the past few years operationally and as well as capital markets wise. The share price was as high as $9 in 2019 but due to a number of things the stock now trades under $0.50. The company went through a fight for control of the company and in mid 2022 activists took control of the company and started implementing cost cuts and operational changes that have resulted in stronger financial performance. | | The company is improving but certainly isn’t out of the woods yet. It is straddled with a fair bit of debt and while cash flow is improving it is operating in a sector that may have some challenges, commercial (office) real estate. In years past it was burning a lot of cash and the balance sheet was starting to get stretched and if you're not generating cash it gets very hard to pay the interest on your debt let alone pay down principal. As of last quarter the company currently had roughly US$63 million in debt and about U$19.5 in cash. “Approximately $1.9 million of cash was generated by operating activities in the third quarter of 2023 compared to $10.7 million of cash used in the third quarter of 2022, with cash increasing $0.6 million overall in the third quarter of 2023. Our cash flow has improved compared to earlier quarters due to improved gross margin, our cost reduction initiatives, strategic actions and careful working capital management.” So the company has debt but is operationally cash flow positive with a fair bit of liquidity (Cash and borrowing capacity).. "As at September 30, 2023, the Company had $19.5 million of cash on hand and C$14.6 million ($10.8 million) of available borrowings, compared to $10.8 million of cash on hand and C$7.2 million ($5.3 million) of available borrowings as at December 31, 2022. Through the first nine months of fiscal 2023, the Company generated $4.7 million in cash flow from operations, compared to a cash usage of $47.5 million over the first nine months of fiscal 2022. The Company benefited from the receipt of $7.3 million of government subsidies during the first half of 2023." The potential opportunity…. The majority of the debt is in the form of two different convertible bonds. The January 2026 bonds (DRT.DB) pay 6% interest, are convertible at $4.65, and are due January 31, 2026 and the December 2026 bonds (DRT.DB.a) pay 6.25%, are convertible at $4.20, and are due December 31, 2026. Both these bonds are listed and trading. Here are their charts: | | | Both are trading at rather deep discounts to their face value, likely suggesting that investors believe there is a low likelihood that they will be paid out in full at the time they become due. The implied yield to maturity at the last traded price for the bonds is roughly 34% on the DRT.DB and roughly 33% on DRT.DB.a. If these bonds are paid out at the end of the term and based on the last trading prices, an investor stands to receive, at maturity, the full face value of $100 plus accrued interest for an annual return of 33-34%. Here’s a bond yield calculator you can play with to see how to get to that yield: https://dqydj.com/bond-yield-to-maturity-calculator/ Now for the interesting stuff…. The company just closed and exercised a rights offering that will net the company C$29.25 million. The stated use of the proceeds are to pay down debt and for general working capital purposes. Basically this means they want to strengthen the balance sheet. The company stated “The Company expects to use the proceeds of the Offering to reduce its outstanding indebtedness by any one or more of several means, including tender offers, open market or privately negotiated repurchases, or redemptions of its Debentures, or through prepayments or repayment of necessary operating lease facilities and amounts outstanding under the Leasing Facilities. The Company also expects to use the proceeds of the Offering for general corporate purposes, which may include investments in its business, funding potential future cash needs or operating losses, or funding working capital and capital expenditure needs. There can be no assurance that the Company will be able to successfully reduce its outstanding indebtedness, on favorable terms or at all.” With rights offerings like this there is usually someone or some entity that backstops the offering by committing to exercise whatever rights are not exercised by shareholders via a standby purchase agreement. In this case 2 major insiders are backstopping the rights offering basically assuring that the full $30 million in gross financing from the rights will be received. “In connection with the rights offering, the company has also entered into a standby purchase agreement with 22NW Fund LP and 726 BC LLC and 726 BF LLC (collectively 726). Subject to the terms and conditions of the standby agreement, each standby purchaser has agreed to exercise its basic subscription privilege in full and to collectively purchase from the company, at the subscription price, all common shares not subscribed for by holders of rights under the basic subscription privilege or additional subscription privilege, up to a maximum of $15-million each, so that the maximum number of common shares that may be issued in connection with the rights offering will be issued and the company will receive aggregate gross proceeds of $30-million.” That type of commitment leads me to believe that the debentures are very likely to be paid out at maturity since these insider’s equity will be worthless if the debentures don't get fully paid back. I also think there is likely to be a stronger bid under both sets of bonds as the company starts to try and buy some of them back from the rights offering proceeds. So, what I think we have here is a set of deeply discounted convertible bonds that have a better chance of maturity at full value than the market is currently pricing in. Clearly these bonds still carry risk and I still have to dig deeper to fully understand more about the business and to gain more confidence here. I want to stress that I have a lot more work to do here and there are many more details I want to flush out. That being said, I bought a small starter position of the December 2026 bonds (DRT.DB.a) at $50. So far I like what I see. I’ve also made a new thread in the SCD forum as I do more due diligence on this opportunity and welcome anyone else’s input. If you are interested in digging in alongside us, feel free. I’ve titled it “crowd-sourced due diligence” and I’ll be adding more information as I dig it up. That’s it for now.
To your wealth, Paul and Trevor |
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