Smallcap Discoveries: Weekly Update: September 18

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Subject: Smallcap Discoveries: Weekly Update: September 18 - 22

September 18 - 22

Market Commentary

Markets

There are two things driving the equity markets right now, higher energy prices and higher interest rates. Higher oil prices are stoking further inflationary pressures and with hit the fear of stubbornly high inflation lasting longer than expected. One is helping to drive the other higher and both are weighing on equity and bond markets pushing both lower. With the US Fed talking hawkish and suggesting interest rates are likely to stay higher for longer market volatility is increasing and stocks are being sold.

North American equity markets are finally showing strain from higher rates. The DOW was lower this past week by 1.8%, Nasdaq was hit harder dropping by 3.6%. The TSX however felt the most pain dropping by 4.1%. Most North American equity markets seem on the verge of taking out recent lows which could spur on further technically induced selling.

If the past is any indication expect that growth stocks will underperform value stocks. The “magnificent seven”, the leaders of the recent bull market, Apple, Microsoft, Amazon, Google, Nvidia, Tesla, and Meta, are likely to underperform as investors take profits and rotate to safer places.

Financials

All eyes and ears were on the US Fed this past week and even though the Fed held rates steady the speech by Jerome Powell was enough to scare investors into believing that relief in the form of lower interest rates was not coming anytime soon. Treasury yields hit new 16 year highs. We have to go back to 2008, the start of the Great Financial Crisis, to see the last times treasury yields were this high.

These higher treasury yields are keeping the US dollar in demand and the US dollar index is back testing 9 month highs.

Much like US treasuries Canada bond yields are testing 16 year highs and putting further upward pressures on most loan rates including mortgage rates. This is in turn putting pressure on the housing industry and we are seeing more signs of resale housing and new construction slowdown.

The Canadian dollar saw some strength this past week almost reaching $0.75 vs the US dollar before backing down before the close on Friday.

Commodities

Oil prices calmed down after three weeks of strong gains. The Fed’s hawkish stance and the continued weak data from China has energy investors taking a pause. WTI oil prices seem to be consolidating the recent bullish move and closed the week above $90 at $90.33.

Natural gas prices have been gaining ground of late. Higher natural gas prices in Europe are putting a bid under North American prices and gas is once again testing $3, the upper range of its 7 month trading range.

We haven’t spoken too much about industrial metals lately. Most metals continue to be range bound but I’m keeping my eyes on copper again to see if it stays in its recent range as it’s back to testing the lower band of that range. A break below $3.60 may be a signal that global industrial output is weakening quicker. Copper futures closed the week at $3.70 per pound.

Stocks

Equity markets are at the mercy of the big stocks and since most big stocks, in my opinion are expensive, I’m not surprised to see the increase in volatility and drop in the indexes. Big markets are being rattled because big stocks aren’t cheap. Remember, the best insurance you get when it comes to buying stocks is to buy them cheap.

I’m starting to sense a bout of déjà vu is on its way. Late last year we saw interest rates crank higher and the high flying big tech stocks and those money losing meme stocks everyone owned took a boot to the teeth as investors rotated out of growth stocks and into value stocks.

Higher interest rates, and especially a rapid move in rates, cause system stress. We saw that stress manifest itself into a pension plan crisis in the UK and a regional banking crisis in the US. We should keep an eye out for cracks in the system again.

I view the market right now being made up of the haves and the have-nots, especially in the small and microcap stocks. They either have cash and cash flow or they don’t. Remember the numbers I mentioned in a recent write up, roughly 13.5% of the listed companies in Canada under $500 million market cap showed a profit last quarter. I imagine of the remaining 86.5% that are losing money I’m sure many have decent balance sheets but I’m going to try and stick with the companies that are adding cash to their balance sheet not decreasing cash.

And if you weren’t already convinced that cash and cash flow are important look at the following chart. Small and microcap companies that are profitable and generate positive cash flow, as a group, far outperform their money losing comparables, and not by just a little bit, they far outperform them. They have a CAGR of about 16% since 1999 vs 0% for those that can’t generate positive free cash flow. I’m sure if you went even further back in time we’d see similar statistics.

If an investor were to be able to generate a 16% CAGR they’d make it into the investor’s hall of fame. Warren Buffett’s Berkshire Hathaway has a CAGR of 8.03% since 2000 vs the S&P’s 6.44% in that time frame.

Cash flow has always been important but for a while cash itself was viewed as trash. You wanted to spend it as fast as you could. You wanted to borrow as much as you could. Cash was almost free. It was being given away. Cash is king now. Cash gives a company staying power and some degree of security. Not just because it’s the lifeblood of a business but now those companies with decent amounts of cash are getting a decent return on there bank balances.

Cash gets harder to come by when interest rates increase. Those money losing companies that will need to go to market to raise capital will find fewer willing funders and the cost of that capital is getting more costly by the day. Cash is no longer trash.

Other Stuff

We highlighted one of our old favorites this week, Thermal Energy (TMG.V). This is a bit of a blast from the past as it was a company that made it onto our buy list back in early 2020 at $0.10 and exited in 2021 at $0.27 for a healthy 170%. The pandemic stopped the company’s growth and consecutive quarters of profitability, and it was only last quarter that the coming got back into profitability. We are very bullish on the longer term outlook for the company and will be watching out for it’s Q4 earnings report which should be out this coming week. I’ve purchased a substantial starter position, roughly 600k shares, and will be looking for a reason to add more.

TMG.V made it onto our new “Cheapies With a Chance” list, which will be out very shortly. Not only do we believe it’s a stand alone great company, but we think it’s a great way to play higher energy prices. Higher oil prices and higher natural gas prices only make the business case for TMG’s energy saving products even stronger. We hope to have an interview with management shortly after financial results are reported.

The SCD Investor Conference is only 17 days away. 20 companies are confirmed to present, and we are still trying to squeeze one or two more in. There are still tickets left. Contact Trevor if you need any help. We are looking forward to hosting you all soon.

REMINDER TO BOOK YOUR MANAGEMENT MEETINGS AND 1X1'S. IF YOU NEED HELP, OR THERE ARE NO TIMES AVAILABLE, PLEASE CONTACT TREVOR.

TREVOR@SMALLCAPDISCOVERIES.COM

This Week I’m Re-reading: Richer, Wiser, Happier – Richard Green - How the World’s Greatest Investors Win in Markets and Life

To your wealth,

Paul and Trevor

Buys and Sells This Week