I sell BGSF and declare an official end to a long and lucrative relationship with micro cap stocks. I look past the current market turbulence and review the portfolio from a more optimistic perspective, with an eye to the next business expansion. I also try to figure out where we stand after the recent market mayhem.
The Results Are In
My review of first quarter results is finished. In the end, I stuck with the initial 4 stocks that I highlighted in my last blog post. I was hoping I could add one or two additional holdings to that list but, as frequently happens, the companies I had my eye on didn’t stand up to close scrutiny. They are on my watchlist and perhaps a buying opportunity will be presented in the months ahead.
I did make one additional change, in the final accounting. I sold my stake in BGSF. The sale of their warehouse staffing division a few months ago forced me to lower my earnings estimates going forward and brought the stock price closer to what I considered fair value. While management commentary was generally upbeat in the latest quarterly conference call, they did allude to some concerns about the possibility of a looming recession. I wanted to sell something to raise additional funds to buy into the recent new portfolio additions and BGSF was coming up as the least undervalued of my current holdings. I thought it might also be one of the more economically sensitive of my holdings and so I opted to sell this stock to make room for the new recruits.
The last week has been a bit of a wild ride for the markets. I was excitedly and apprehensively awaiting Signet Jewelers’ first quarter results. I bought into this one at the beginning of last week, a few days before Q1 results were due to be released, in the hopes of catching some upside from a strong earnings report. I rushed my portfolio update to the presses, largely on account of trying to get the word out in time on this stock, in case others wanted to do the same. Initially I thought I was very clever as those first quarter results were indeed quite robust and the stock price immediately popped 10%. I was patting myself on the back and feeling like a swell guy for all of about 24 hours. Then inflation numbers came in red hot, the markets tanked and so did the price of Signet Jewelers, along with everything else I had just bought. Bloody hell.
The lesson I’m taking away from this little episode is this: in the future, unless there’s a good reason not to, I’m going to try and wait until I’ve completely finished my periodic quarterly reviews before issuing my final analysis. This means there could be a delay of a week or two between the time I buy into a new stock and the time I finish my review and blog about it. Sometimes the stock price will have moved up in the interim. Sometimes it will have moved down. Most of the time it probably won’t have moved much at all and over the longer term, it should all even out. The advantage of waiting to post until I have the full picture is that those of you who are following my market movements more closely will also have the complete picture, instead of being fed it piecemeal, and can make your own portfolio rebalancing decisions with all the facts in hand.
A New Chapter
Micro cap stocks were the cornerstone of my portfolio from the very beginning. Generally defined as stocks with market capitalisations of less than $300 million, these tiny companies mostly fly under Wall Street’s radar. Rarely followed by professional analysts, they are the playground of small-time investors. In this exciting, but often ignored corner of the market, you can find some real gems, companies like Bowflex or MTY Food Group (two early, micro cap entries in the portfolio) that someday could be destined to grow into multi-billion dollar enterprises. There are also more than a few spectacular flame-outs as well, but that is all part of the excitement. With micro cap stocks, you don’t have to worry about competing with the big boys and their Bloomberg terminals or their armies of analysts. You’re competing on a more level playing field with other individual investors like yourself. The person on the other end of that buy or sell order could be your grandma or your dentist or your chatty neighbour. It’s not likely to be a multi-billion dollar hedge fund.
For a new investor starting out, I think micro cap stocks are a great place to cut your teeth. The companies are small and easy to understand. The annual reports aren’t the length of a small novel. You can learn the company inside and out in half a day. If you call up the company, you’re likely to get the CEO or the CFO on the phone and they’re often pretty excited to be talking to someone who is actually taking some interest in their company.
And it’s fun! These are companies no one has heard of. They’re often doing exciting, innovative things. There’s a real treasure hunt feel to the search for new, undiscovered ideas. They can also be very lucrative. If you take the time to sift through all the dross (and there is a lot of dross in this sector) you can unearth some real gems in the early stages of their evolution that can go on to grow spectacularly. You can also unearth some incredible bargains simply because no one else is paying any attention.
As I say, I played in this space for many years. Until relatively recently, the majority of my portfolio has been in the micro cap sector, with a few small, mid and large cap stocks sprinkled in for good measure. But sadly, success comes at a price. The micro cap sector is what it is because the big boys can’t play. The trading volume in these small stocks is low enough that it is just not feasible for larger players to get involved. The stocks may trade only a few thousand dollars worth of shares a day and some days may not even trade at all. A mutual fund with $50 or $100 million to invest is not going to be able to buy enough shares in any sort of reasonable time frame to make any difference to their fund’s performance. And if they tried, they would quickly drive up the stock price and cancel out any pricing opportunity that might have existed in the first place.
While I am no market behemoth, I too started having difficulties playing in this space in the years following the recovery from the Great Financial Crisis. For a long time, I found ways around it. I bought a larger number of positions, I spent weeks patiently trading in and out of the stocks I liked. I focused on the more heavily traded corners of the micro cap market. I looked for micro cap opportunities in other markets like Hong Kong or the UK.
In short, I did everything in my power to keep playing in this space as long as I possibly could. But over the last four years, since launching this blog, I’ve come to the slow and painful realisation that the jig is finally up. It was a fun ride while it lasted but I need to face facts. The micro cap sector is largely beyond my reach at this point. Trying to stay in it is hurting my results more than helping them.
I decided to unload my holding in BGSF a couple of weeks ago to help raise funds for the new portfolio additions but found that this was easier said than done. BGSF is a micro cap stock and more thinly traded. I probably drove down the price of the stock in my eagerness to raise cash for the new acquisitions. When I forced myself to step back and take a break from unloading shares for a day or two, the price quickly rebounded.
My big fear is getting stuck in a stock that I can’t get out of. It’s an excruciating feeling to own stock in a company that releases bad results and then be forced to trickle out your position in dribs and drabs over weeks or even months before you can finally make a full exit.
It’s taken me awhile, in a very public forum, to finally come to terms with the idea that my micro cap days are largely behind me. Except for the occasional more heavily traded micro cap stock like Preformed Line Products, I’ll mostly be concentrating on small, mid and large cap stocks going forward. I have raised the trading volume limits on my stock screen so that it only shows me the stocks that I can realistically get in to and out of in a reasonable amount of time. I find as a general rule of thumb that I can trade about 1/3 of the daily trading volume of a stock without unduly affecting the share price.
Especially in Canada, this rules out an awful lot of very interesting companies. In fact, once I apply this trading volume restriction, along with a few other broad criteria, I’m left with a short list of barely over 100 companies that still fall within my wheelhouse. 100 companies is not enough to construct a decent portfolio from. Give me a list of 100 stocks that I have never seen before and I would generally expect to come up with 1, maybe 2 that were cheap enough to consider investing in.
Which brings me to the other major evolution in the portfolio. Not only have the past 4 years seen me dragged kicking and screaming out of the micro cap market, they’ve also seen me dive headfirst into the US market.
With a dearth of opportunities in Canada, the US was the obvious choice for where to expand to next. The US equity markets are the largest in the world. This is the epicenter of global capitalism, at least for now. Whereas there are around 100 stocks open to consideration here in Canada, in the US, I’ve got more than 1000 to choose from, even after I apply my basic screening criteria. But it’s a heavily followed, exhaustively scrutinised market. Finding undiscovered gems there is no easy feat. Not impossible, though.
Just like the shift away from the micro cap sector, my transition into the US markets has occurred in the very public forum of this blog. I imagine I’ve made a few mistakes along the way although heaven forbid, I actually own up to any of them. At this point, though, the transition is largely complete. I’ve got a good feel for the markets south of the border now. I’ve got my spreadsheets up and running, I’ve got all the relevant historical data in place. I’ve reviewed the market top to bottom enough times now to recognise the companies that regularly show up on my low-priced screens. I’m starting to feel at home.
The Proof Is In The Pudding
I think the value investing principles I follow are fairly universal. They’ve worked in the foreign markets I’ve ventured into, and they seem to work across the market cap spectrum. I’m optimistic that they’ll continue to work even as my investing focus shifts and the market environment changes.
The last few years in the market have been incredibly turbulent. And it was during this turbulence that I was edged out of the micro cap market and also into the US market, both major changes to what I was doing previously. It will only be in hindsight that I can really gauge how well I’ve performed with this shift in market focus, but so far, so good.
Today, in fact, is a good day to take stock. Since the market peak in 2007, I’ve outperformed the Russell 2000 by about 10% a year. (10.8% to be precise.) Today, in fairly spectacular fashion, the Russell 2000 came crashing down through its high-water mark of 4 years ago (although it’s still up 12% when you factor in the dividend). Over the same 4 years, my portfolio has gained over 60%. That works out to an average outperformance of 10.5% per year, almost exactly in line with what I was able to achieve in the more sheltered confines of the Canadian micro cap space. Despite all the trials and tribulations of the last four years, despite the wild market swings caused by a worldwide pandemic, in the face of bored apes and eccentric billionaires, and despite a significant change in my own focus and direction, value has reigned supreme. Yay.
Lay Of The Land
It’s always hard to get a clear reading on exactly where the market stands. Market averages are always distorted by certain sectors or market cap segments that may have relatively little bearing on the kinds of stocks I buy. While I like to look at long-term graphs of various valuation ratios and market performance over time, I often find it equally helpful to pay attention to what my own empirical observations are telling me.
With this latest review, I was using a fair value p:e of 16 to anchor my investigations. That’s for a small cap company, with a reasonable debt load, growing sales and earnings at the market average of 5-10% a year. From what I could see, a company like that, in today’s market, seemed to be trading for around 16 times earnings. Or, more precisely, 16 times my estimated earnings, which currently are trending below actual reported earnings, sometimes by a wide margin. I’m still expecting profits to give back a lot of those covid gains.
In the grand scheme of things, though, this is looking downright reasonable. At its peak last year, these sorts of companies briefly traded as high as 23 times earnings, certainly higher than I had ever witnessed in my 26 years in the markets. Hence the incessant whining and complaining last year on this blog.
But things are better now. Stock prices have come down (and continue to come down. fast!) At the same time, earnings have climbed, although part of that I believe is temporary. Inflation has played a role. Corporate profits are actually a pretty good inflation hedge. If prices in the economy double, you’d generally expect corporate profits to double as well. If it wasn’t for the fact that the ratio of stock prices to those corporate profits tend to decline during inflationary eras, stocks would be a great place to hide. As it is, they tend to be only so-so.
Stepping further back, since I’ve been active in the markets, I’ve seen p:e ratios for the sort of small cap company I’m describing swing back and forth between 12 and 20 several times. They traded near the lower end of this range in the years following the bursting of the internet bubble, during the depths of the Great Financial Crisis and briefly in the panicked early days of covid. At the other end of the spectrum, they touched the high end of that range in the late nineties, again in the 2004-2007 era and finally in the 2014-2020 time period.
So at the current level of around 16, we are comfortably in the middle of the p:e valuation range of the last several decades. At this level, I’d be inclined to say that stocks were neither cheap nor expensive. And by that reasoning, stock prices really could go either way from here and it wouldn’t surprise me.
Which all sounds fairly reassuring. Now, just to throw a bit of shade on this party, if we pull our frame of reference back even further, things look a little less benign. I’d label the last 26 years as the “easy money era”. Asset prices in general have been high and rising throughout this time period. I like to blame it on the baby boomers all trying to save for retirement at the same time. But now that they’ve all mostly reached retirement age what happens next? Obviously, you could take a negative view. But then again, demographic projections show that society doesn’t get any younger from here on out. We keep getting older, in fact, for decades to come. Retirees tend not to spend down their nest eggs very quickly. They prefer to live off the interest. Maybe boomers will do it differently. They’re a pretty spendy generation. So we’ll have to see. But it’s no slam dunk that this era of easy money is over just yet. Asset prices and average p:e ratios could stay relatively high for years to come.
But if they don’t, we’re looking at a possible decline of 50% from where we stand today to get back to the levels of the 1970’s, even after the recent market drop. Not the likeliest scenario, but something to be aware of. Just so you don’t get too cocky.
Undeniably, we are in a better position today than we were at this time last year. Stock prices have come down. Yields are higher. Still, though, I think there are probably a lot of value traps out there right now. Companies that look cheap on a p:e basis and yet really aren’t because the ‘e’ part of that equation is about to take a tumble. There were a lot of companies that enjoyed blockbuster profits during covid and much of this still has to be walked back. The challenge is always trying to figure out if the low p:e of these value traps already fully prices in the expected profit reversion or not. The boat sellers, the RV makers, the home builders. They all sport single digit p:e ratios. The market may have already sufficiently priced in a cooling off of covid demand. Has it overshot the mark? I’m not taking the bait yet, but I’m watching.
What about Big Tech? Here’s where you see the most dramatic price declines. Price drops of 50-75% from their peaks of last year are not unusual. As any value investor worth his salt would do, of course I went looking through the sector looking for potential bargains. Here too, I see a lot of value traps, if you can call a stock with a p:e of 25 a value trap which, in the bizarre realm of cyberland I guess you can. Yes, prices have come down dramatically and yes, p:e ratios, on a trailing basis are starting to look a little more reasonable but only if you assume that those earnings are going to stay elevated and further, that the company is going to keep growing those earnings at the same breakneck pace of the last few years. For the most part, I’m not willing to make either of those assumptions.
But at least I can start to understand where investors in these companies might be coming from. If sales were to double, then double again and the company was able to earn a decent profit margin on those sales and you put a high final multiple on the resulting earnings number then, yeah the stock price looks reasonable. That’s the kind of math I could do with Shopify or Tesla to make the current reduced share price make sense. But those are extremely strong assumptions. I don’t feel comfortable being that breathlessly optimistic. Personally, despite the price declines, I don’t think we’ve seen the bottom in this sector yet.
The energy sector seemed like it might hold some promise as oil and gas prices rip higher. There have been several years of under investment in this sector and that could conceivably force prices higher and keep them there for longer. The green energy revolution is going to require lots of natural gas to keep things running smoothly and prevent frequent and repeated power outages. A shortage of battery metals may slow the rush to electric vehicles at least somewhat. Any way you look at it, the pivot away from fossil fuels is going to be rocky and as much as we might wish it, we’re not completely done with oil and gas just yet.
In the past, I’ve played heavily in the oil and gas service sector. Drilling companies, frac sand providers, nitrogen pumpers, waste disposal specialists; there are lots of companies engaged in servicing this sector. I went looking through that list, searching for some value-priced opportunities but came up empty handed. All the companies I looked at were already fully pricing in a dramatic and lasting return to the level of drilling activity we saw in the early 2010’s when oil was riding high and the fracking revolution was in full swing. But my expectations are not quite that rosy. I do expect activity will pick up strongly this year as high commodity prices finally drive producers back into the field, but I’m reluctant to bet on the kind of full recovery that stock prices seem to already be factoring in. I tried hard to convince myself to buy in to Peyto Exploration and Development, a Canadian company specialising in natural gas. They’ve got a great track record and a world class set of assets but again, I just couldn’t make the valuation work for me. There’s potential upside there, for sure, but it requires high and sustained gas prices to get there and I don’t know. I don’t want to make that my base case. I want to make money even if oil and gas don’t make a dramatic comeback. After all, this is likely an industry in its twilight years. Let’s not get carried away here.
In the end, what I was left with was my usual dog’s breakfast of undervalued situations. The only grand narrative or overriding theme here is that they are all cheap. Good, or at least halfway decent companies, selling for excellent prices. And I’m more than happy with that.
As I write this, the markets are taking it on the chin. Inflation is red hot and the Fed has backed itself into a corner. The assumption is that they are going to jack up interest rates to kill the inflationary beast and the economy is going to be collateral damage.
Fair enough. It could play out that way. However, a lot of the inflation we are seeing is a holdover from the covid craziness. And the Russians. But it could all come to a screeching halt tomorrow. That’s what the well-known Canadian economist David Rosenberg is forecasting and I have a lot of respect for his views. We could be back to our money printing, asset loving, disinflationary ways before we know it. Never get too sure that you think you know what’s going to happen, ‘cause you don’t.
Recessions don’t scare me. Sure, profits get knocked down for awhile but they come back. The kinds of companies I buy are rarely in danger of going under. And by the time everyone recognises that we are actually in a recession, stock prices have usually hit bottom and are on their way back up. As Peter Lynch said, investors have lost more money preparing for recessions than they have lost during them.
A secular decline in valuations does scare me, but that’s something different. It’s not fair to tarnish the noble recession with that brush. A regular recession is a healthy way to clear the air, get rid of the more egregious excesses (NFT’s anyone?) and set the stage for the next big business cycle expansion.
The companies I own are typically not that defensive. I don’t like utilities (too much debt), I don’t invest in REIT’s. I stay away from the big banks. I tend to be much more drawn to the consumer discretionary companies than I am to the consumer staple ones. The Signet Jewelers of the world instead of the Loblaws Grocers.
So this means if we are headed for a recession, the portfolio is likely going to take a hit.
As if the car makers weren’t struggling enough already, now they’ve got a recession to contend with. Linamar is no doubt going to feel some heat. All the big advertising companies got whacked a few weeks ago when Snapchat came out with their guidance calling for a drop in ad spending. Omnicom was part of that group. I did sell Foot Locker and BGSF, two companies that I think could take it on the chin in a nasty recession. But I stuck with Skyworks and Stella-Jones. People are probably going to be buying a few less $2000 iPhones and maybe hesitating before they drop $5000 on lumber for a new deck. If demand really cools off, the price of copper could take a nosedive and that will not be good, in the short term at least, for Ero Copper.
But with many of my stocks now trading in the single digit p:e range, the near term is not where I am focused. I am looking further ahead to the next big up-cycle and my mouth is starting to water.
Linamar, for instance is trading at a price to book ratio of 0.8. Profits are down now because of the chip shortage and supply chain issues which is why I’m using book value as a substitute here for p:e. During the mid point of the last business cycle, Linamar was trading above 2 times book on a book value that had doubled from its lows of the previous recession. Do the math. Double your book value and triple or even quadruple your p:b valuation and you get a pretty spectacular run for the stock price. They continue to diversify away from their reliance on the automotive sector with another recent acquisition in the farming equipment space. They say they are getting a record number of orders for the new wave of EVs that will hit out showrooms as soon as the supply chain gets unkinked. Everyone who has put off buying a car (including me who is trying to nurse another year or two out of a very rusty 15 year old Toyota Matrix) is going to be clamoring for a new car and it is going to take years to replenish inventories. Linamar is one of my two biggest holdings.
The other one is Signet Jewelers. Q1 results came in strong and the company still believes it is on track to report record earnings after completing a major restructuring. I suppose people will buy fewer expensive diamond rings during a recession, but at a p:e of only 5 to projected earnings, even if we have to wait an extra year or two to get there, this looks like one of the best setups I have seen in quite awhile.
Hammond Power came out with a stunning first quarter. Earnings were off the charts and their outlook is for continued strong growth as their backlog swells. This company did very well during the commodity price boom of the late 2000’s/early 2010’s and then struggled during the resource bear market of the last 6 or 7 years. If we are entering a new era of resource scarcity and a resulting resource boom, perhaps these results are just a foreshadowing of what is to come. Unless I see otherwise, I’ve ratcheted up my earnings expectations for this company and as a result, it is looking like a solid value even after the significant runup in the share price. It’s a thinly traded micro cap so I can’t own too much of it but I’m very happy with the shares that I do have.
I won’t say too much about the new stocks I bought since I just blogged about them last week but I will say that I am a sucker for a rock-bottom p:e. With the drubbing that Sylvamo has taken in the last few days, the p:e ratio has fallen down into the 5 range and that gets my juices flowing. I’ve been adding more to my position as the price drops. Granted the upside is probably not as great as with some of my other holdings as they are in an industry that is in slow, secular decline. But with a p:e of 5, I don’t care. That gives me a potential earnings yield of 20%. Let’s milk those legacy paper mills for all they’re worth!
Skyworth and Omnicom are my two large cap holdings. Large caps are still trading at a big premium to small cap stocks. The average p:e ratio in this segment is still north of 20. Meanwhile, Omnicom and Skyworth are on the verge of sinking into the single digits. How can you not get excited about that? Omnicom has a long, steady, stable track record. Results may have eased off a tad during the last recession but they quickly recovered and went on to continue their steady upwards climb. This is one of the world’s leading ad agencies. With all the new and exciting ways to market your products, it seems to me like the next decade could be a great one for Omnicom. And I can buy into it at only 10 times earnings.
Likewise, Skyworks seems to have a bright future in front of it. They are right at the forefront of the wireless connectivity revolution that may be about to unfold. The Chinese automakers are leading in the new EV domain and they say that consumers over there are treating their cars like smartphones on wheels. This and other connected applications promise years of growth ahead for this company. And again, with the shares on sale right now, you can pick it up for around 11 times earnings.
And finally, I was listening to the Odd Lots podcast the other day on why copper may be one of the tightest markets the world has ever seen. The title pretty much says it all and has me excited about owning my little piece of a Brazilian copper mine.
The Only Constant Is Change
As always, pros and cons, plusses and minuses, hems and haws. The cycle turns and the game continues…
Full disclosure: I own shares in Skyworks, Omnicom Group, Signet Jewelers, International Money Express, Sylvamo, Preformed Line Products, Stella-Jones, Linamar, Ero Copper and Hammond Power Solutions. I do not own shares in Tesla, Shopify, BGSF or Foot Locker.