Smallcap Discoveries: Weekly Update: October 16

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Subject: Smallcap Discoveries: Weekly Update: October 16 - 20

October 16 - 20

Market Commentary

Markets

Markets continue to face the headwinds of higher bond and treasury yields.

week while Nasdaq was lower by 3.2% and the TSX was down 1.8%

As you will see by the chart below, 6-month treasury yields now yield higher returns than the S&P 500 for the first time since the implosion of the dot-com bubble in 2001. By this measure stocks, when measured by US large caps, are clearly expensive.

Financials

All eyes continue to focus on interest rates and specifically the US 10-year treasury as once again yields hit new multi year (17 year) highs. The cost of capital, the lifeblood of almost every business and debt fueled consumer, keeps getting more expensive.

US dollar treaded water this week closing mostly unchanged.

I keep watching the Canada 5 year bond yield for any signs of cracking. There is clear evidence that home sales are grinding to a near halt in Canada as high real estate prices combined with high mortgage rates make it near impossible for many to be able to afford a home. As home sales and construction are such a large part of the Canadian economy and such a hot political issue these days I’m expecting any slowdown to have an impact of GDP and eventually interest rates.

The Canadian dollar continues to weaken as investors come to grips with a slowing Canadian economy especially when compared to the US. It looks likely that the Bank of Canada will likely keep interest rates steady or even start lowering rates response to any economic weakening sooner than the US Fed and we’ll see that effect the Canadian dollar.

Commodities

The escalation in tensions in the Middle East continue to impact oil prices. WTI oil is back testing the $90 a barrel level closing at $89.20.

Natural gas prices saw further weakness this past week on higher than expected inventories. I’m waiting to see if we see similar concerns for European natural gas supplies as we head into winter. Last year’s milder winter in Europe allowed the continent to escape an expected energy shortage.

Baker Hughes reported 2 mire drill rigs activated in the US and a further 5 more rigs in Canada. Drilling activity still trails the level we saw at this time last year. Stronger North American natural gas prices may be needed to see a more robust level of drilling activity this winter.

Gold had another good week as it quickly regains its safe haven status. Gold is up roughly 7% since the start of the month as geopolitical tensions overshadow higher treasury yields and a stronger US dollar. Higher yields and a strong US dollar are usually quite negative for gold.

Stocks

In my opinion, the stock market is very expensive, but I’m still a buyer.

We have to always remember that the “stock market” is a market full of stocks. Many different companies with different prospects and different individual characteristics. While the stock market as a whole may follow the economy different companies react differently to different economic factors. And then add in human biases and human emotions and it’s not unusual to see certain stocks acting completely independent of the overall markets.

I’m been screaming it for the last year at least, that while big stocks have looked expensive smaller stocks, especially profitable and growing smaller stocks still look extremely cheap. This is why I’m still a buyer even though the big markets make me nervous. There is always a bull market somewhere and I think it’s in those profitable and growing nanocaps.

I was very pleased to see another contract announcement this past week from Thermal Energy (TMG.V). This past Tuesday the company announced an additional $2.6 million heat recovery order. That’s $4.5 million in new orders announced just in the past two weeks. I draw attention to the number of Project Development Agreements (PDAs) the company referenced in the CEO’s letter to shareholders. In 2023 the company received 25 PDAs compared to just 10 in 2022. These PDAs are potential projects that TMG evaluates on behalf of the potential customer. Here’s what they said:

“In addition to order intake and order backlog, activity pertaining to PDAs is an important indicator of momentum in our business and a key metric in assessing the strength of our business development pipeline. In fiscal 2023, we received 25 signed PDAs (including seven in the fourth quarter) compared to ten signed PDAs in the prior fiscal year. While our custom equipment orders have been steadily on the rise for some time, we are excited to see a significant year-over-year increase in the number and value of signed project development agreements. Although there is no guarantee that signed PDAs will result in completed turn-key projects, the surge in agreements demonstrates the growing demand for our carbon emission reduction and energy efficiency solutions by our Fortune 500 and other large multinational customers.”

With a historical conversion rate of 75% we can expect that the 25 PDAs should turn into roughly 17 new orders, and at an average project size of $2 million, that’s $35 million in expected new orders over the coming year give or take. This is over and above their current record backlog of existing orders. So we can expect to see at least one new order per month or more over the coming year. I can see much higher prices for shares of TMG.V. For a bit of an idea where I think share price of TMG is going I suggest listening to the most recent free-for-all from this past week.

We interviewed Xybion Digital (XYBN.V) this past week and coincidentally they reported their delayed financial results a few days prior. As per the company website: Xybion is a global SaaS company that helps enterprise life science organizations accelerate new drug development into approved medicines that may save lives and keep employees safe. It digitizes drug research and development, laboratory testing, regulatory approvals, and pharmaceutical manufacturing on a single, unified cloud platform that is cost-effective, ready to deploy and easy to use. Xybion has over 160 clients in 29 countries using its low-code software to accelerate timelines, improve compliance, expand capacity, minimize operating risks and reduce expenses while keeping employees safe.

Xybion is what we would consider a broken IPO. The company initially went public at $3.60 and prior to this past week traded as low as $0.37. View the interview and you’ll better understand the possible reasons for such a poor share price performance. With only 1.5 million shares in the tradable float and 97% insider ownership, now that the company has filed a nicely profitable quarter, this company is worth keeping on the radar screen. Shares in XYBN.V closed up 18.5% on the week.

Other Stuff

Over the coming weeks I’ll spend some time describing the formula we use to try and find companies that have the propensity to outperform the markets, potential multi baggers. As some of you know we have a set criteria we use to determine what companies, mostly nanocaps and microcaps, that have the common traits that we have historically seen to give us the best chance of early discovery of long term compounders. I’ll try to describe what these criteria are and why we believe they lead to strong outperformance.

Growth

If you want to find a stock that has the chance to multi bag it’s almost impossible to have that happen with out seeing strong growth in the business and while that is obviously the desire of almost every business it’s much harder to come by than most people think. We aren’t talking about potential growth. We want to see existing growth, growth in revenues and of course more importantly growth in profit. And the faster the growth the greater the potential for growth in share price, faster growing companies increase value faster.

A mistake I see a lot of investors make is they think they have to buy potential growth to get outstanding results. I can tell you from experience that what you want to find is existing growth that the market isn’t valuing properly. Thermal Energy from above is a great example.

Another interesting dynamic investors struggle with is that they have a hard time properly valuing rapidly growing companies. Investors tend to have a bias towards traditional value investing, where balance sheets and book value tethers their idea of what value actually means. This leads them to tend to under-price rapidly growing companies, especially when they are still small and have all of a sudden hit some kind of important inflection point. What this allows sophisticated investors to do is buy hyper growing companies at realistic “value” type of prices. You’ve probably heard the term GARP (Growth At a Reasonable Price), in the nanocap and microcap sector often you’ll get the chance to enjoy GASP (Growth At a Stupid Price).

Sometimes investors struggle valuing hyper growing nanocaps because many of these companies operate in niches and investors struggle to understand what the total addressable market may be and if it feels small then investors can’t see long term growth. I love small companies that are starting to dominate a niche market. They tend to be able to maintain higher margins because of lack of competition and often find parallel niches to exploit and grow. Almost all big companies started as small companies and by exploiting a niche.

Ok, so when we look for revenue growth, we look for companies growing fast, ideally at least 25% year over year or greater. And it’s important to point out that we are looking for that growth on a per share basis. It’s almost always pointless to grow revenues at 25% if the company is issuing 25% more new shares. In rare instances growing the share count and revenue may have a positive impact on the earnings per share but when all things are equal we want to default to growth per share.

We look at quarterly performance first and we want to see this result on a year over year basis. Sometimes there is some seasonality in the business and some quarters are seasonally stronger or weaker and we need to account for that. If there is no seasonality and revenues are consistently growing every quarter this is even better. And more quarters of hyper growth means more likeliness that growth will keep going at a similar pace. Remember though, there is the law of small numbers. It’s easier to grow smaller revenues at a fast pace than it is to grow very big numbers at a fast pace. It is usually why historically smaller companies used to garner higher valuation metrics (price to earnings, enterprise value to earnings etc).

Give more weight to latest quarter. We are watching for inflection points and many times it will show in a quarterly report. This could be triggered by the launch of a new product, an acquisition, a new business division, new business model or a host of other things. We want to identify why there has been a strong change in revenues. And watching for early inflection point likely means we are at a very early stage of the discovery process.

We also want to watch for growth in other metrics, ie bookings, backlog, deferred revenue etc. One great place to find these metrics are in the company’s MD&A. We love to review the MD&A for clues as to why there has been a big jump in revenues and perhaps if this change has staying power.

A company showing a rapid rate of growth is usually an indication that the company’s products are finding their mark. A growing number of customers want the product or want more of it. Revenue growth can tell you so much that it should not be ignored. And unlike companies that promise growth this promise has already been realized limiting the risk that the company doesn’t meet its promise. How many times have we seen companies with great promise and potential just not show those results. A bird in the hand is worth two in the bush….

By no means is rapid growth in revenue the only thing to look for but it is a vitally important metric if you want to shrink the large list of investment opportunities to those that have a strong chance of turning into a multi bagger.

Next week we’ll talk a bit about what we look for in terms of a company’s profitability.

This Week I’m Reading: Trading in the Zone – Mark Douglas - Douglas uncovers the underlying reasons for lack of consistency and helps traders overcome the ingrained mental habits that cost them money. He takes on the myths of the market and exposes them one by one teaching traders to look beyond random outcomes, to understand the true realities of risk, and to be comfortable with the "probabilities" of market movement that governs all market speculation.

To your wealth,

Paul and Trevor

Buys and Sells This Week