Smallcap Discoveries: Weekly Update: September 19

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Subject: Smallcap Discoveries: Weekly Update: September 19 - 23

September 19 - 23

Market Commentary

Market

World equity markets were down hard this past week with the Dow trading at new lows for the year closing down 4.0% for the week. Nasdaq was down 5.1% and the TSX managed to stay above the year low but not far from it closing down 4.7% for the week.

The US Fed hiked interest the much expected 75 basis points but the hawkish speech by Fed chairman Powell was enough to make nervous investors hit the sell button. The US dollar was sent screaming higher and pretty well every other asset class was sent lower. Investors now expect interest to stay higher for longer.

While there is clear evidence the rate of inflation is slowing, for the US Fed it’s clear that it isn’t slowing fast enough. With a near risk free rate of over 4.2% on the US 2-year treasury note investors are happy to start parking cash on the sidelines. The 2-year US treasury note yield is up almost 4 full percentage points since this time last year or to put it in a different perspective it is up 1905% off the low (0.21%) it was yielding this time last year. Yes, a 19 bagger!

With capital this much more expensive is it any wonder that so many assets are being re-priced. While the volatility of this latest move is likely to continue to shake up the markets, we are starting to see extreme oversold conditions once again. The extreme volatility can cause things to break so while I believe we have many stocks that are oversold it would not surprise me to see a capitulation type event. Margin calls and hedge fund implosions can happen in times like this. Monday will be an interesting day.

Energy

Higher rates and a stronger US dollar are impacting energy markets. WTI oil fell below $80 per barrel, a level very few believed we would see. Consider that we still have the conflict in the Ukraine, we still have energy chaos in Europe, no resolution for the Iran nuclear/oil discussions and we had Saudi planned cut in production.

Natural gas felt the pressure this week as well and settled below $7 for the first time in a few months.

And gasoline, which was a big contributor to inflationary pressure earlier this year also continues to weaken.

The Baker Hughes drill rig data continues to show continued strength in drilling activity, especially outside of the US. While we saw one additional US rig in action (+0.1%) we saw 4 more in Canada (+1.9%) and 27 internationally (+3.2%).

While energy price charts all seem to be pointing south right now, we can’t forget the currency math. Non-US based producers are still making good money when you factor in their own currencies. Take Canada for example, with the Canadian loonie trading below US$0.74 producers here in Canada are getting prices considerably higher in Canadian dollars for their barrels.

Speaking of currencies…. Stable currencies are not supposed to behave this way. The Cad/US dollar chart looks like so many other currency charts, although Canada has had it better than many. It’s this kind of volatility in currency values that has caused some serious crisis in the past, so we need to watch carefully for what breaks.

Commodities

Again, it’s all about the US dollar. Pretty well every commodity was lower on the weak. I believe orange juice was the only major commodity that closed higher last week. (My guess is that the markets are causing an increase in day drinking….. Bartender, a screwdriver please!).

Gold hit fresh new year lows.

While copper is within a few nickels of its year low.

Weakening world economies, especially in China, along with the historic strength in the US dollar will likely continue to put pressures on industrial commodities.

Stocks

Admittedly, I did not think we would see the markets test, and as for the DOW, break recent lows. Sentiment has gone from bearish to BEARISH. Capital has continued to move to the sidelines. That said I still believe we have incredible risk/reward opportunities in our sandbox, the smaller quality stocks.

Most of the small stocks we follow while lower than recent weeks continue to hold in well. I do believe we have two very different markets. The big liquid markets which are seeing massive capital inflows and outflows and the smaller stocks that have been in a bear market for almost 18 months.

Winning stocks are being sold. Liquidity is being sold. Momentum is being sold. Big stocks are being sold Right now cash is king and everything else is trash. Remember when cash was trash?

Could we see lower prices for microcaps? Of course we can. Microcaps are susceptible to one or two big sellers driving prices lower but so many are trading at such historically cheap prices that this becomes the opportunity. Most microcaps are not margin eligible, but it doesn’t mean they can’t be sold to meet margin calls on other stocks. Fear can affect anyone and cause someone to sell. There are a number of reasons why someone may want or even need to sell their cheap microcap. And even some of the microcap winners are susceptible to selling as many investors prefer to sell their winners and hold on to their losers, something I have learned the hard way is not good for one’s portfolio in the long run. There are cheap microcaps out there that could get cheaper.

The best insurance when investing is buying cheap. Buying assets below their true value. Having a significant margin of safety. This applies when we are in a bull market, and it applies when we are in a bear market. Markets are likely to stay volatile for the foreseeable future. It will cause wild mispricing in all sorts of assets. The price volatility will affect the underlying value and risk outlook of some assets, especially underfunded companies that need a healthy stock price to maintain a viable capital structure or to continue their growth plans. Others company will have almost zero change in their underlying value because of their change (aka drop) in share price. These are the companies we want to be looking for.

I was buyer this past week adding a sizable amount to my Atlas Engineered (AEP.V) holdings. It looks like someone needed to sell a sizable amount quickly. I’m not thinking 2-3 months out, I’m thinking at least 2-3 years out. (Disclosure: I am a director of Atlas Engineered Products)

I continue to believe that these volatile markets will allow for considerable mispricing of great companies and will allow many investors with longer term investing horizons the opportunity to buy stocks cheap and with a considerable margin of safety. It won’t feel easy, it will feel scary at times but if you look back in history you will see that more times than not these were the times, the scary times, to maintain your wits and look for those great mispriced opportunities.

“Be fearful when others are greedy and greedy when others are fearful.” Warren Buffett

No Canslim Contender this week.

Buys and Sells This Week