Bucking the Trend

It’s no secret that 2023 was a rough year for the smallcap market. A simple snapshot of the TSX Venture index shows this story quite clearly:

Inflation, high interest rates, global instability with the predictable flight to safe assets—the list goes on. There was a growing wall of worry for investors to get over, and for many this meant the last thing on their minds was investing in a smallcap.

These types of companies, also known as “penny stocks”, have a well-known reputation for being a terrific way to lose money. And this is because most stocks in this space are not profitable, are highly diluted, and are often more of a fad, chasing the latest trend with the same players at the helm.

To put it into context, of the 3,500 companies on Canadian exchanges, only about 350 make any money. And as we’ve noted many times, of this 350 you’re looking for an even smaller number—the companies that have solid fundamentals, low market caps, and are growing—the 5%.

Bucking the trend

When we look at what happened in 2023, it was a tale of two different sides of the smallcap market.

On one side, there were the smallcap companies that needed money. This represented most of the smallcap market, which faced a difficult year. They just couldn’t get any cash, as financing was non-existent. The result was a plunge in stock values (of the 90% money losing companies) across the board, taking the whole market down.

But on the other side, there were the smallcaps with money, and making more of it. This group performed much better. In this group, we saw more than 30 companies bucking the trend, delivering a strong year with many up well over 100%. They displayed stellar performance in a brutal market, going against the sentiment. And the interesting thing is that there was no specific sector that stood out; it was a complete mix.

A couple of winners include: ADF Group (TSX: DRX), Cipher Pharmaceuticals (TSX.V: CPH) , Firan Technology (TSX: FTG), Kits Eyecare (TSX:KITS), Vitalhub (TSX: VHI), Enterprise Group (TSX: E), Atlas Engineered Products (TSX.V: AEP), Thermal Energy (TSX.V: TMG), McCoy Global (TSX:MCB)

The lesson here is simple . . .

Stick to the fundamentals

The money tide going out in 2023 proved that fundamentals are the ultimate thing that really matters. It’s a simple lesson, but a hard one to remember in this space because when a fad takes off and money comes in, even junk can go up quickly.

The companies we follow tick most of the boxes in this list:

  • year-over-year revenue growth per share of at least 25%
  • at least two consecutive quarters of profitability
  • low share dilution
  • high insider ownership

If you stick with these, you will increase your chances of finding the next gem and seeing great returns, even in bad years.

Of course, it also pays to keep an eye on the bigger changes coming down the market.

Follow the money

Money moves in cycles, and this means that the current cash-starved smallcap space will not be in its current funk forever. In fact, there are signs that things are starting to change.

We are seeing an increasing number of takeovers and go-private transactions, further reducing the supply of investable companies. Some recent takeovers and go-private transactions include: H2O Innovations (TSX: HEO), MediaValet (TSX: MVP) Opsens (TSX: OPS)

As companies are taken out, investors redeploy pools of capital back into the market, with an increased appetite for strong returns. This leads to financings and a big boost in attention towards smallcaps.

As a reminder, institutional money is currently almost non-existent in this space. This money has been completely absent in recent years, due to a range of factors, leaving the smallcap market to retail investors, who lack the funds to really move valuations.

When this big money shows up it has an enormous impact. Most importantly, these big players are only able to step in when a stock gets to a certain size (e.g., $100 million market cap). So, if you are following one of the companies we talk about, which has doubled in the last year, and you are reluctant to buy into its sub $100 million market cap, just remember that if the big money shows up this valuation will seem tiny in comparison.

For example, this is what happened to ADF Group in 2023. It went from zero to plenty of institutional ownership, and the chart says it all:

The next ADF is out there. It may even be a company we’ve already covered like Thermal Energy International (TMG.V), which had a great run in 2023. At a sub $50 million market cap, it may seem a bit pricey for those who did not ride the recent wave, but compared to ADF and its recent moves it may also just be getting started.

Looking ahead

While it’s great to see that fundamentals win out over trends, it’s also important to keep your finger on the pulse and the investment opportunities that these trends represent.

For instance, we are seeing large homebuilders in the U.S. having a considerable run. This has been years in the making, as supply challenges and strong demand are pushing the housing market. The same factors are impacting the Canadian housing market, and we expect the attention on large US companies to slowly trickle down to larger Canadian companies. The next in line would be medium sized companies, and then smallcaps.

At the same time, the return of the local supply chain continues, as more and more companies bring manufacturing back onshore. Spending on manufacturing facilities in the US has been strong, and we see no reason for this to slow down. Buying the boring companies making things that “hurt when dropped on your foot” has proven to be a smart strategy over the last couple years, and it will likely continue.

As for further ahead, it’s anyone’s guess what fad, macro trend, or other development will influence the market. But if you stick to looking for strong fundamentals and sift through the noise, chances are good that you will find the gems, no matter what the broader market is doing.