Smallcap Discoveries: Weekly Update: July 31

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Subject: Smallcap Discoveries: Weekly Update: July 31 - August 4

July 31 - August 4

Market Commentary

Markets

Happy long weekend to my Canadian friends.

North American equity markets lost ground this past week as initial concerns over bond rating agency Fitch downgrading of US debt citing mounting debt and “steady deterioration in standards of governance.” Markets were also shaken by weaker than expected labor data and some big name tech earnings disappointments. Apple (AAPL) helped take Nasdaq lower after reporting its third straight quarter of year over year revenue declines.

US treasury yields spiked early in the week then dropped sharply on Friday after the release of jobs data, adding more concern for equities and resulted in the DOW ending the week down 1.1%. Nasdaq had one of its worst weeks this year dropping 2.8% and the TSX followed suit ending the week lower by 1.4%.

Financials

The US dollar index (DXY) trended higher during the week but ended mostly unchanged by week’s end.

US treasury yields were steady early in the week but saw a sharp drop on Friday

The Canada 5 year bond yield briefly hit a new 15+ year high but spiked lower along with US treasuries.

Higher rates are not what the majority of equity investors are predicting. A break to higher rates likely causes a change in outlook and may be what holds major equity markets back for now. We need to keep a close eye on these yields.

Commodities

Oil has had 6 consecutive weeks of gains and WTI oil is now trading back to where it was back in April. A break above current levels will take it to new 8-month highs and likely triggers another big wave of inflationary concerns.

Baker Hughes drill rig data showed a drop of 5 rigs in the US and another 5 rigs in Canada.

Gold was down on the week but rose on Friday on the back of the slightly weaker than expected US jobs data and drop in treasury yields.

Stocks

Stock markets turned lower for the week. I’m still not comfortable placing any new positions as I’m not seeing very many “fat pitches” lately. Markets feel toppy to me and the small stocks we follow apart from a small handful aren’t offering up enough obvious opportunity that I’m comfortable sitting on my hands for now.

One stock that does look ok for me is CanadaBis Capital. It’s the last stock I’ve added a few weeks ago right around current prices. I’m tempted to add a bit more down here with the stock currently trading around 7.5 times annualized 6 month earnings.

What I’m noticing in the microcap market is that value stocks, or growing companies with value type characteristics, continue to outperform. I’m not seeing any rotation out of them and into any other sector. Money losing growth stocks are mostly out of favor. Story stocks are completely out of favor. I see no reason why this doesn’t continue for now, especially if overall markets start to pull back.

Canadian housing related stocks seem to have caught some strength finally doing a bit of catch up to the US names. Doman Building Products (DBM.T) saw a healthy jump on better than expected earnings.

And Adentra (ADEN.T), a distributor of architectural building products, saw its shares reach its 52 week high.

Many Canadian housing related stocks still lag the moves and valuations we’ve seen in the US home builder stocks. Maybe we are finally starting to see the catch up I’ve been expecting.

Other stocks that saw notable action last week include Hammond Power Solutions (HPS.T) hitting a new 52 week high on the back of strong earnings report.

And sister company (and takeover list member) Hammond Manufacturing (HMM.a.T) reached another new 52 week high as well. Hammond Manufacturing announced a 7.2% increase in revenues but a whopping 133% increase in earnings per share. Shares in Hammond are up 79.1% since their inclusion in our “Takeover Candidates” list on Dec. 28, 2022.

Those results helped the basket of takeover list stocks generate an average return of 60.9% so far to date.

Other Stuff

I’m going to keep this section brief this week so I can get back to my family and try and enjoy the rest of our long weekend.

I wanted to spend some time talking about valuations. More importantly, why valuation matters. Last week I spent some time talking about risk and how price matters when it comes to determining risk, but a big part of “price” is price vs value. Paying a low price for something with little value isn’t likely to generate positive returns in the long run.

We want to pay a low price for something of significant or greater value. I think it was Warren Buffett that said, “Price is what you pay, value is what you get.” We want to buy a dollar for fifty cents.

I notice many investors tend to buy stocks because they are down in price with little determination of whether value is being purchased. In other words, buying only because the price is down. If the value of the company has decreased than so should the price. We need to know what today’s value is or even a future value that can help give us confidence that we are buying at a discount to that valuation. We need to determine value to know if we are buying with a proper margin of safety.

There are a lot of factors that go into determining value which I will save for another time. The key thing to know is that we need to determine what our case for value is. What kind of valuation do we place on a particular stock today and what is the potential future price? What is our method to determine this valuation?

Many use a fundamental valuation approach based on balance sheet alone. Others use a combination of balance sheet and income statement. Some may use a comparison approach comparing other similar companies and using the difference in PE or other valuation metrics to determine a valuation. Many approaches work, the key is to use them.

You should be able to determine a valuation for every stock you currently own. Your goal should be to hold a basket of stocks that you can argue that these stocks trade below that present or future valuation. If you can’t do that it’s either because you don’t understand what you own, or the stock doesn’t stand up to your valuation methodology. Either way it’s not a stock that should give you strong conviction and with out strong conviction you may get whipsawed out or sell too soon or hold a losing position for the wrong reasons.

Build an investment strategy that helps determine valuations. Monitor on a regular basis and ask if that valuation has changed. Compare that valuation to current price. Does the stock still offer you a demonstrable margin of safety? Do others give you a better opportunity? Without a proper valuation strategy, you are investing with a blindfold on.

Investing is hard, use ever tool you can to gain an edge.

This Week I’m Reading: Richer, Wiser, Happier – William Green – How the World’s Greatest Investors Win in Markets and Life

To your wealth,

Paul and Trevor

Buys and Sells This Week