Smallcap Discoveries: Weekly Update: May 15

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Subject: Smallcap Discoveries: Weekly Update: May 15 - 19

May 15 - 19

Markets

It’s a long weekend in Canada so I’m starting this weekly update a bit late after a fair bit of local travelling.

Investor’s appetite for risk seems to have returned encouraged perhaps by strength in the bank stocks and hopes of an agreement on a settlement on the US debt ceiling. Nasdaq led the equity indexes higher increasing 3.0% for the week and is now closing in on the highs for the year.

The DOW was higher by 0.3% while the TSX dropped 0.3% for the week.

It’s interesting to note that several international indexes such as Germany’s DAX reaches a new all time high and Japan’s Nikkei 225 index has broken to multi decade highs and is getting close to it’s 1990 highs.

Financials

US dollar continues to show strength as investors reverse their non dollar holdings.

Part of the reason for the strength in US dollar is more favorable US macro data and somewhat more stable banking environment and weakness in Chinese data.

Treasury yields continue to climb on the back of stronger than expected data and yields are now at levels last seen right around the early days of the recent US regional bank crisis.

Canadian bond yields continue to move in lock step with bond yields in the US and are at their highest levels in just over 2 months.

Commodities

Oil prices were higher for the week even though inventory data showed a large increase of around 5 million barrels versus an expectation of a 1.3 million barrel decline. WTI oil price was up roughly 3% for the week and ended at $71.69.

The US Department of Energy has announced that they will be starting to refill the strategic petroleum reserve with a smallish 3 million barrels, indicating a change in policy and likely puts a floor on prices for the time being. The other bullish news is the International Energy Agency has increased its forecast for energy demand and expects a stronger market for the balance of the year.

The increase energy prices can’t seem to come fast enough to prevent a further slowdown in drill rig activity. There were 20 less drill rigs active in North America this past week. There was a drop of 11 in rigs in the US and 9 in Canada.

Gold spent the week below $2000 an ounce as the strength of the US dollar and slightly higher interest rates weighed on gold prices.

Industrial production data from China shows growth albeit quite a bit lower than estimates and this has kept a lid on demand for industrial metals such as copper.

Stocks

You wouldn’t know we were in a bull market if you talk to investment industry people like I do every week. Investment bankers and advisors I talk to have been quick to tell me how tough markets have been and how little transaction volume they are seeing. Of course, most of these people I talk to operate mostly in the smallcap/microcap space. This part of the market has not recovered or stayed as buoyant as the big stocks and big markets have. Nasdaq is up over 13% in the past 12 months. The DOW is up 6%. The TSX Venture exchange is down just over 14%. Transactional volume is down and financings, the lifeblood of the venture markets, have dropped significantly. The mood is poor in the Canadian microcap industry.

Although the overall Canadian venture market is struggling, many companies that are not dependant on the financing industry (investment bankers, analysts and investment advisors) are the ones bucking the downtrend. Small companies that don’t need money (equity financings) are doing quite well, thank you very much, and are the small companies that seem to dominate the new 52 week high lists on a regular basis. This week, from our watch list, it was Total Telcom (TTZ.V), Enterprise Group (E.T) and H2O Innovations (HEO.T).

Companies that control their financial destiny and are not reliant on the investment industry continuing to provide equity capital are the ones that are outperforming the money burning companies and with only about 5% of the sub $100 million Canadian listed companies generating net cash flow is it any wonder why the small markets are doing so poorly?

Sticking with profitable and growing microcap companies allows investors to lessen their financing risk. Investing is tough enough but when venture markets are weak, like they are now, you don’t need the added worry of a company needing to finance when their stock price is weak. You also get to avoid the negative sentiment of brokers, analysts, and bankers. It’s why many of these great little profitable companies are seeing upward stock prices and new highs.

Other Stuff

We spend a lot of time looking at public companies. We also spend a lot of time and effort looking at small private companies. In looking at both, you get a good sense for what real world valuations look like. Traditionally, a small private company will be valued lower than a similar company that’s publicly listed. From time to time however, the reverse is true. Private market prices are determined by the buyer and the seller. If one or the other isn’t happy with the price there usually is not transaction. However, in the public world, the price of any company on any given day, can be determined by tens or hundreds of buyers and sellers or even more if the company is big enough. Sometimes the price of a small company can be determined by 1 or 2 people buying or selling a small number of shares if the company is small enough. Think about that… the price could be determined by less than 1% of the available shares. It’s why we can see such volatility in small stocks and why we can see such significant mispricing. Low volume, illiquid stocks tend to have serious mispricing from time to time.

I was thinking about this this past week as Trevor, and I, visited a small private company. It’s a great little profitable company. Like thousands of baby boomer business owners, this owner wants to retire and has his business up for sale. This owner has had a small handful of potential buyers come and look at his business. The owner knows what he has, he knows the business he owns. A new buyer needs to do a lot of due diligence to get up to speed with the business and to determine a value. A decision to buy a company like this is a big one and the time, effort, and due diligence to come to a buying decision is quite sizable.

What if public market investors took this type of approach when it came time to look at buying shares in a public company? Would that improve their performance? Which route is riskier?

Business buyers, in general, take much more time and effort to buy a private business. It’s not necessarily because there is more risk, it’s likely because there is less recourse if they change their mind once they own it. Public market investors can “trade” out of a position in seconds if they change their minds. A private buyer can’t. These are long term decisions.

In most instances I try to take a private buyer approach when I buy publicly traded companies. I’m trying to take a much longer term approach. The kind of due diligence isn’t that different.

Think about the microcap investing landscape. We estimate that 95% of listed microcap companies in Canada are currently losing money. Historically, the odds of these companies getting to profitability is quite low. They are the types of businesses that would have a hard time finding a private buyer at anything close to what they currently trade for in the public markets. Most are really just start ups that are hoping to grow into real businesses. I’d argue very few private buyers would be interested in these types of companies. Yet they attract investors. Mostly investors that buy into the dream quickly.

Some of the best investors I know are past business owners. They take a similar approach to buying shares in companies as they did in their businesses. They apply longer term thinking. They also know the ups and downs of running a business. I also find most of them shy away from money losing companies. They gravitate to businesses that are easy to understand and valuations that make sense.

As I reflect back on some of the recent private company visits, I’ve had it refreshes my eagerness to find these simple easy to understand businesses that throw off cash. I’m happy to let other investors chase the sexy, story stocks. Stick to buying real businesses, know what you own, and think like a long term business owner. It’s worked very well for me over the years, and I see no reason why that will change.

Interesting Quote of the Week

From Ian Cassel – “Holding losers is easier than holding winners. Why? Because losers always look cheap.”

What I’m Reading

I’m currently reading (and very highly recommend) “The Gambler” by William C. Rempel – How penniless dropout Kirk Kerkorian became the greatest deal maker in capitalist history.

To your wealth,

Paul and Trevor

Market Commentary