Smallcap Discoveries: Weekly Update: October 10

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Subject: Smallcap Discoveries: Weekly Update: October 10 - 14

October 10 - 14

Market Commentary

Markets

These are interesting times in the markets. On Thursday we had the US CPI data released. Inflation, once again, was hotter than anticipated and as one would expect the market sold off quickly. But then something strange happened, the market started a face ripping rally before ending the day significantly higher. The DOW rallied 1508 points or 5.3% from its intraday low and finished the day up 828 points (2.8%). The DOW finished the week up 1.2%. Nasdaq finished the week down 3.1% and the TSX finished off 1.4%. The delayed reaction to the CPI data surprised many investors. Could it be that this “bad” news is priced into the market? Is the short trade now the crowded trade?

When bad news is no longer sold into it usually means that everyone is already out/short. An up move on bad news is quite bullish. It’s usually a sign of a bottoming process. It’s not a reason to go nuts and turn full on bullish but it should put investors on alert. There continues to be a lot of reasons why the economy will slow down and certainly volatility and uncertainty can be expected be the norm for the near future but with all the cash on the sidelines and record retail shorting the market is ripe for a strong rally.

Energy

It was a rough week for energy investors. WTI oil dropped over 7% for the week, erasing some of the big gains from the previous week closing Friday at $85.61 per barrel. Natural gas was weaker closing at $6.45. North American energy prices continue to be strong enough to encourage more drilling activity as rig activity jumped by 8 rigs this past week, 7 new rigs started operations in the US while Canada added one more rig.

Commodities

Precious metals are back down testing 2 years lows again. Gold just can’t seem to find any strength against the strong US dollar.

Most other major commodities were flat to slightly lower for the week.

Stocks

Most economic data I’m seeing is pointing to an economic slowdown. While inflation has been stubbornly high for longer than most would like, it is coming down. The question now is will it come down slowly or will we see it start moving down faster. Some say that we are in a new paradigm, and we can expect inflation to stay elevated longer and perhaps the Fed needs to change their 2% inflation goal, as the medicine to get there would be far too painful.

There is plenty of leading data that is starting to point to the likelihood of some rapid slowing in business conditions and slowing of product/service demand. Take trucking jobs for example. Trucking jobs saw the largest monthly drop since 2009.

Trucking hiring/firing tends to lead nonfarm payroll data.

The strong US job market is one of the drivers of the strong inflation data. With a slowing job market we can expect a slackening of consumer demand. For the time being, the US consumer continues to show resilience in the face of higher prices.

The economy, both in the US, and even more so, outside the US is slowing. The US economy has stayed stronger for longer than many have expected forcing the Fed to raise rates faster than at almost anytime in history. For now, it seems the markets have been reacting to higher interest rates by heading lower as rates rise. Long duration treasuries are beginning to price in the economic slowdown. Earnings have held on better than many expected and have helped to buoy the market somewhat. But while almost all stocks are down, most large stocks, especially the old market leaders, still look overpriced if we start factoring in a significant global slowdown. Last week I highlighted a few well-known big caps that are trading at double digit PE ratios yet are growing revenues at single digits or in some cases shrinking revenues. The bigger stocks seem to be pricing in less of a slowdown than many smaller stocks I follow. I believe there is too much of a disconnect between the large caps and smaller caps. The big stocks still look expensive to me, and the smaller ones seem much cheaper. Regardless of where the economy goes from here the pricing mismatch looks appealing.

Earnings of these big stocks are likely to weaken as the economy slows. A higher US dollar is already starting to impact many large international players. These companies dominate the market and have a major influence over the exchanges. If they go down so will the exchanges. But will the same happen to microcaps that are already trading at historically low levels? Likely, yes but probably more for liquidity reasons not valuation reasons.

In the small universe of microcaps that I follow I’m noticing another interesting trend. Certain microcaps are holding up or performing much better than others. These are what I call the the blue-collar companies. Companies that make stuff that if you dropped it on your foot it would hurt. Companies that are capital equipment intensive, capital intensive. You’d think that in an environment of higher cost of capital (higher interest rates and lower equity prices) these companies and their stocks would suffer greater than capital light businesses but that’s not what I’m seeing.

I don’t spend a lot of time looking at big caps so I’m not fully aware how prevalent this trend is there. The industrial company heavy DOW is performing much better than the technology heavy Nasdaq.

A big reason why I think these stocks are doing better than most is because they’ve been out of favor for so long. The attention, and investment capital, has gone to the “capital light” businesses. SAAS offerings, software, ad-tech, fintech, ed-tech, ag-tech, you-name-it-tech, these companies were getting sky high multiples because they could easily scale and with almost unlimited growth, they were given high valuations. “Cash was trash” and cash flow generating companies weren’t as sexy as hyper growing, yet money losing companies. Remember Cathie Woods’ ARK Innovation fund? The “capital light” company dominated fund is down 79% from it’s high.

Who in their right mind would want to invest in a North American manufacturing operation, a metal fabricator or God forbid a refinery? Companies engaged in capital intensive businesses like manufacturing, heavy transportation and resource extraction have had a harder time getting investment capital. Regulatory burdens, ESG concerns, and skilled labour shortages only added to the hurdles. But demand for these products didn’t go away and with supply disruptions, energy disruptions and political concerns around the world suddenly existing producers became much more valuable. Existing facilities are significantly more valuable today due to inflation, the cost of replacing existing operations and the higher barriers to new entrants. In some cases, it would be cheaper to buy these operations than it is to build new.

Location matters too. International based operations are riskier now. Semiconductor chips for example have rapidly become strategic and critical to industrial output. Security of supply is now a political issue and we’ve seen the push to bring semiconductor manufacturing back to the US. Energy and a number of other strategic commodities are being viewed the same. There are many more important products that will be brought back closer to demand markets and to friendlier producers than in the past.

The cost of transporting heavy goods is becoming more expensive due to energy costs. The higher cost of energy in some countries (ie anywhere in Europe right now) is making finished goods uncompetitive. Localized manufacturing is becoming a strategic and economic imperative.

Some Canadian manufacturers are in an extremely enviable position. Canada borders the largest and currently strongest economy in the world. Its energy costs are one of the lowest in the world thanks to cheap natural gas and abundant hydro electricity. And with the Canadian dollar nearing multi decade lows it gives Canadian based sellers to the US even more competitive pricing advantages.

And could it be that the Canadian government may have figured out that we actually have advantages to exploit and the world, and especially our trading allies, need what we produce? Just this weekend the Federal government announced that Canada will fast track energy and mining projects important to our allies. I won’t be holding my breath but at least it’s another indication of the strategic value of certain goods and commodities.

With these factors at play will these boring, capital intensive businesses get investor attention? I think they will. The world is changing, and I think both Canada and some of these companies are not only positioned to benefit from these changes, but they are already heavily discounted to begin with, giving investors an extra degree of opportunity.

It shouldn’t matter much to investors if these advantages were priced into stocks, perhaps it is in some of the larger stocks and maybe why some are still trading at premiums to small stocks, but many small companies that have the same advantages I spoke about above are still trading at significant discounts to their larger comps. The argument could be that these are somewhat cyclical stocks and they should trade at these levels as we enter a recession and earnings decline, but shouldn’t the same apply to the big guys?

Price matters when it comes to investing. It’s hard to make money buying good companies if you overpay for them and you can still do well owning bad companies if you under pay for them. Howard Marks has made a fortune buying distressed assets at significant discounts. But what I see in some of these smaller companies are good companies trading at distressed values.

We’ve seen what has happened recently to shares of Inventronics (IVX.V). I think it’s the poster child for what I’ve described above. A small manufacturer that has been able to grow very rapidly due to a changing economic environment and it’s done it from an extremely low valuation. I see the same scenario with Circa Enterprises (CTO.V) and Supremex (SXP.T) and Canadian energy producers and service companies. These are all double-digit growers trading at single digit PE multiples and new competition for these businesses face big hurdles to compete.

I continue to believe that these are some of the opportunities that give us the best risk/reward opportunities in this market right now. I love buying things when few others are competing with me. Baron Rothschild was famously quoted as saying “Buy when there is blood in the streets” I prefer to buy when there is no one in the streets. Right now, in many of these single digit PE double digit revenue growing boring businesses there are very few investors out in the streets buying.

Other Stuff

I was interviewed by Michael Gayed, fund manager and the author of the Lead-Lag Report. You can listen to the podcast here.

More concern over Canadian housing shortages

No Canslim Contender this week

To your wealth,

Paul and Trevor

Buys and Sells This Week