Smallcap Discoveries: Weekly Update: September 5

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Subject: Smallcap Discoveries: Weekly Update: September 5 - 9

September 5 - 9

Market Commentary

Markets

After 3 consecutive down weeks which moved North American equity markets into oversold territory stocks rallied nicely this past week. The DOW was higher by 2.7%, Nasdaq jumped 4.1% and the TSX was up 2.6%. Investors seemed to gain courage as the holiday shortened week progressed. Most investors continue to be bearish but the fact we’ve bounced without taking out the June lows will give the bulls some momentum. My feeling is that is if markets can break above the August highs, we could see a dramatic sentiment change and would likely see a strong short covering rally. We continue to believe that there is s strong chance that we have seen the lows and continue to see data that suggests that most investors are too bearish, too much cash is on the sidelines, and the necessary conditions are in place for a very strong rally.

Some headline news continues to keep the bears happy. The European Central Bank (ECB) raised key interest rates by 75 basis points last week, Covid lockdowns in China continue and the employment picture in Canada is rapidly deteriorating. Canadian employment data was considerably weaker than economist’s forecast as the country shed 40,000 jobs versus the 15,000 jobs gain that was expected. The Canadian economy has now lost 114,000 over the past 3 months.

Inflation data continues to soften.

International freight rates continue to decline rapidly.

While we have seen a number of commodities head lower in price the past few months there may be much more to come. If the historic correlation between freight prices and commodity prices were to continue, then freight prices could be forecasting a significant further drop in commodities.

Used vehicle prices continue to drop in August. Used vehicles are a 4% weighting in the CPI and dropped by 3% last month. Gasoline dropped by 12% in August and has a 5.2% weighting. These two items alone would be a 0.75% drag on August CPI. It’s quite possible we could see a negative headline reading for August CPI.

Even airfares appear to be dropping after the summer of “revenge travel” as almost everyone wanted to take a holiday at almost any cost to make up for being cooped up during the pandemic. While we are all still reeling from pandemic and supply shock inflation many goods and service prices are starting to fall rapidly. Part of this is due to slowing demand but a lot of it is due to a normalizing of supply chains and inventory rebuilding.

I believe central bankers will soon have to decide whether the slowing inflation data is enough to pause or change interest rates downwards to stave off a more painful economic downturn. With so many investors still betting that central bankers will continue tightening and forecasting a bad recession any change in that sentiment could drive a lot of capital back into the equity markets. More on this a little later….

Energy

WTI oil closed down for the week and Brent oil traded below $90 for the first time since the start of the Ukraine conflict. Even with the token 100,000 barrel OPEC+ announced output cut wasn’t enough to stem the bleeding.

Natural gas traded below $8.

This week’s North American land drilling activity saw a slight slowdown as we saw a drop of 4 active rigs according to Baker Hughes.

Commodities

Commodities were a mixed bag this past week. Gold was mostly flat while industrial metals such as copper and steel were slightly higher.

Stocks

Bank of America Says Small Caps Cheaper Thank Since the Dot-Com Bubble….

That’s the title I saw this week and while I hadn’t seen data to corroborate this it’s been “feeling” like this for some time now. The small stocks I’ve been following do look very cheap while the overall markets and the big names we all know have still looked expensive. I’ve been droning on about this for months. We are finding cheap stocks. Double digit revenue growth at single digit PE ratios.

When money leaves the equity markets it dries up liquidity. Fund managers hate illiquidity, they move up market and stick with the names they know and set aside a lot cash just in case they have to meet withdrawals. Smaller investors get scared they go to cash or to “safer” investments. The disparity between large and small stocks grows and you get cheap stocks in the smaller stock segment.

The last time we were here was back in the turn of the century. Nasdaq was decimated by the burst of the tech bubble. The high-flying tech growth stocks were out of favor and value stocks were back in vogue. Value mattered, profit mattered, strong operating fundamentals mattered again.

Small stocks tend to have major rallies after a prolonged down move and in some cases these valuation discrepancies with large stocks actually signal market bottoms.

Bull markets die when everyone is in. Bear markets die when everyone is out. The twitter polls I keep running indicate a roughly 75% bearish stance versus a 25% bullish stance. This is about as negative as it gets. Investors have been pulling money out of the market for months.

Investors in the UK, like most major markets have been pulling money out of the markets at near record rates.

Roughly £12 billion in net cash has been withdrawn from investment funds since the beginning of the year. The most in over 10 years. Most of this cash has been moving into low returning savings accounts and money market funds. The UK is not alone. Global investors are ditching equities for the “safety” of cash.

So, with all this cash that has moved to the sidelines what happens if there is a change in narrative? What happens if the Fed pivots? What happens if we get some positive news on inflation and interest rates?

Markets and investing in general are seldom binary. It’s not black or white. There are changing degrees of risk/reward almost daily. Yes, the world economy looks bad. Yes, there are plenty of things to worry about. There always is. But how much and what has been priced into this market and more importantly in our universe of stocks, the small guys. We’ve seen a brutal bear market in microcap stocks over the past 18 months. I would argue some stocks have priced in a near depression, let alone a recession or “soft landing”. A bull market climbs a wall of worry. Early bull markets always look scary. New stocks tend to lead new bull markets, old bull leaders tend to lag.

With all the cash that has moved to the sidelines, with the large discount between large and small stocks and with the overwhelmingly bearish sentiment that overhangs most investors the situation is ripe for a sustained bull move higher. With so many small stocks trading at very depressed valuations even if I’m wrong and the markets don’t move to the upside so many of these companies have low downside because of these valuations. But if I’m right and we do enter a bull market from here, the upside on some these stocks could be life changing. It’s hard to be bullish when the headline sound so bad but this is how you get maximum price distortion to the downside and maximum potential upside.

“Audentis fortuna iuvat”…. Fortune favors the bold….

Canslim Contender

CECO Environmental – (CECE-Nasdaq)

Closing Price: $9.80

CECO Environmental is a leading environmentally focused, diversified industrial company, serving a broad landscape of industrial air, industrial water and energy transition markets across the globe through its key business segments: Engineered Systems and Industrial Process Solutions. Providing innovative technology and application expertise, CECO helps companies grow their business with safe, clean, and more efficient solutions that help protect people, the environment and industrial equipment. In regions around the world, CECO works to improve air quality, optimize the energy value chain, and provide custom solutions for applications including power generation, petrochemical processing, general industrial, refining, midstream oil and gas, electric vehicle production, poly silicon fabrication, battery recycling, beverage can, and water/wastewater treatment along with a wide range of other applications.