Smallcap Discoveries: Weekly Update: July 24

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Subject: Smallcap Discoveries: Weekly Update: July 24 - 28

July 24 - 28

Market Commentary

Market

It was another solid week for equity markets this week. Solid corporate results and no surprises from central banks allowed the bulls to carry on their buying. The DOW reached another new 52 week high this week and closed the week up 0.7%. Nasdaq ended the week up 2.0% with almost all that gain coming on Friday. The TSX bucked the trend and had a small loss of -0.1% for the week.

Equity markets continue to price in either stronger earnings, a less hawkish Fed, or some other bullish outlook as equities have shrugged off one of the fastest interest rate increase and 15+ year highs in interest rates.

Financials

The US dollar, measured by the DXY, had another move higher this week as the bounce continues from its brief stint below 100. The trend still appears to be lower and as the risk trade gains strength I’m guessing we’ll see another test of the 100 level soon.

The Canadian dollar is holding on to its new trading range. Not much new here this week.

Both US and Canadian interest rates continue to trade up against multi year highs and, if they stay at these elevated levels, will start to have bigger impacts on their economies. The other possible outcome and one that seems to be more in favor currently is that central bankers will be in a position to lower rates as inflation continues to weaken. Investors and equities seem to be betting on lower rates.

In Canada we saw a number of major banks increase mortgage rates as the Canada 5 year bond yield once again is testing the 4% level.

Commodities

We have now seen 5 consecutive weeks of higher oil prices. WTI oil closed the week above $80 for the first time since April. Higher prices for longer will bring confidence back to the oil patch and if we can see a stronger tone to natural gas prices we likely see a renewed demand for drilling services.

According to Baker Hughes North American the number of drilling rigs active last week increase by one rig. In the US 664 (-5 from last week) rigs were active while in Canada 193 (+6) rigs were active. This time last year there were 767 rigs active in the US and 204 active in Canada. We’ve seen a drop of 11.7% in North American drilling rig activity. The big international energy service companies have seen strong moves in their share prices while smaller stocks have gone sideways at best. It may be time to dust off our notes and look again at some of the energy service microcaps.

With the US dollar slightly stronger on the week gold moved in the other direction. Gold needs to move back above the psychologically important US$2000 to get the bulls back in full force. Gold closed the week at $1958.50 per ounce.

Copper seems to be gaining strength as global economies particularly China and US economic data comes in better than expected. Strength in those two large economies will increase demand for industrial metals while long term copper supply concerns create upwards pressure on the metal.

Stocks

My bullish stance on equities weakens as prices seem to continue to defy gravity, especially on the big boards. Big stocks just continue to climb higher with what seems to be a blindness to higher rates and historic valuation metrics. I keep seeing two different markets, big stocks that just keep getting more expensive and small stocks that at best are going sideways. The big boards’ technical outlooks still look bullish and it’s hard to argue against new 52 week highs, but we have to remember that risk is largely determined by the price you pay, and higher prices does increase the level of risk if there isn’t a corresponding increase in value. Are markets less risky than they were 6 months and 30-40% ago? Nasdaq is up 40% from the lows it reached at the start of the year.

“Be fearful when others are greedy and greedy when others are fearful.” Warren Buffett.

Market strength seems to be concentrated on the belles of the last bull market, big tech. Lots of semiconductor names and Alphabet (GOOG) and Meta Platforms (META) hitting 52 week highs.

I’m going to stick to my smaller, cheaper names.

Other Stuff

I’m a big fan of Howard Marks. Mr Marks is the founder and co-chairman of Oaktree Capital Management. Oaktree is a global investment manager specializing in alternative investments. Mr. Marks is well known for his skill in investing in distressed debt. Inspired by his regular memos and the current book I’m reading “The Most Important Thing” I wanted to talk about risk and how I look at risk in relation to my investing approach.

Risk cannot be looked at without considering the price you pay for an asset. Great companies at high prices can be riskier than poor companies at very cheap prices. The price you pay may be more important than what you are buying.

Prices are affected by a number of things, but ultimately it’s driven by supply and demand. Supply and demand drives prices, but what affects supply and demand? I can spend hours going over all the things that can impact supply and demand, but in the interest of time I’d like to speak to one theme that I believe is most important when it comes to investing in equities and even more so with microcaps, and that is ~ Investor sentiment.

We are going to get into what Howard Marks refers to as “second level thinking”. The average investor uses something called first level thinking. For example, company “A” just released a news release announcing an increase in earnings. First level thinking would assume that this will cause the stock price to increase. Second level thinking would ask “Was this level of earnings already priced into the stock price?” or “Is there an audience for this news?” or maybe “Is overall investor sentiment too negative to care?” before assuming what the likely direction of the stock may be.

Both demand and supply can be affected by investor sentiment. Poor sentiment can mean a lack of buyers and/or an increased amount of selling. Second level thinking will ask what current sentiment may be for a stock or sector and what is likely to change it. This type of thinking will always ask what is priced into today’s price for an asset?

Stock buyers should be looking for assets that have a lot of negativity priced into a stock. The flip side for those looking to sell. If you have a stock that has had a very strong run it may make sense to ask how much bullishness is priced in? What can go wrong to this expectation? Sentiment works both ways.

Let’s try to put some of this into practice. This past week we interviewed 2 different cannabis companies. Grown Rogue (GRIN.C) and Rubicon Organics (ROMJ.V).

The cannabis sector has been a disastrous sector of late. After a meteoric rise in prices for many weed related stocks, many of the high-flyers have come crashing down, with some declaring bankruptcy, and many others down 95%+ from their bubble highs.

The sector has caused a lot of pain, especially for investors that were late to the game. Financing's for many of these companies, which in the bubble days were plentiful, have all but disappeared. We are seeing forced selling as some companies declare bankruptcy. Billions of dollars of investor’s capital have been vaporized. Who in their right mind would be bullish on the sector? Tell an experienced cannabis investor that you are considering investing in the sector, and they’ll look at you like you’re growing a second head. Sentiment is about as bad as it gets. And it seems to be priced accordingly.

In comes second level thinking…

The first question I ask is “Is too much negativity priced into the sector?” and “Are their assets that are being improperly affected by this negativity?"

We’ve highlighted 2 stocks in the sector this year that we felt were worthy of owning, Grown Rogue (GRIN.C) and Canadabis Capital (CANB.V). Both are up by over 100% in the past 6 months. This while the sector is down massively. Both companies are fighting against the negative sentiment, and I would argue are still considerably under-priced because of that sentiment, even though they have recently seen a large increase in their share price. I had dinner recently with an analyst that covers the cannabis sector and he had never heard of these two companies. It brought a smile to my face. These two successful, growing, and profitable little companies are still off the radar screen. Negative sentiment will cause people to stop looking at the things that have been causing them pain…

We see this type of thing all the time in the stock markets. Hype cycles that cause extreme bullishness and bubbles only to results in extreme bearishness and massive drops in prices. The dotcom boom and bust, the peak oil energy bubble, cannabis, blockchain etc. All have had extremes in investor sentiment. They will continue to come and go. But if you apply second level thinking and try to determine the risk and what is priced into the current share price, you may save yourself some grief and maybe find opportunities where others are afraid to look.

In my opinion microcaps in general are still facing considerable negative sentiment. Very few institutional investors are interested in the sector. Many retails investors are too afraid to buy illiquid stocks. Very few TV pundits are recommending small illiquid stocks. Sentiment is weak.

And there is another type of microcap stock that is starting to get me interested. These types of stocks have been shunned for a few years now, supply is dwindling, and up until recently, I’ve been quite negative on these types of companies, but the low prices are starting to look very appealing to me. They are so out of favor that I think it’s time to start taking a deep look to find some gems and hopefully take advantage of this mispricing.

Remember, risk is more a function of what you pay rather than what you buy.

“Investment success doesn’t come from “buying good things,” but rather from “buying things well.” Howard Marks

Stay tuned…

This Week I’m Reading: The Most Important Thing – Howard Marks – Uncommon Sense for the Thoughtful Investor. I’m a big fan of Howard Marks. This book does a great job of reminding me that risk/reward is heavily associated with the price you pay for an asset. A great company at a high price can be a poor investment while a poor company at a cheap price can be a great investment…

To your wealth,

Paul and Trevor

Buys and Sells This Week