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January 27, 2021

What Kind of Microcap Market Is This?

What Kind of Microcap Market Is This?

Regardless of the global pandemic, and the related economic uncertainties, equity markets have been skyrocketing. Elon Musk has become the world’s richest person as Tesla (NASAQ: TSLA) nears a $1 trillion dollar market cap, Robinhood traders are ruling the markets, SPACs have made a resurgence, real-estate markets are climbing, practically all commodities are trending higher, and Bitcoin is absolutely flying. With both large-caps and small-caps trending higher, global equity markets are hitting new highs, in a rip-your-face-off rally.

It’s clear equities are red-hot. And, over the past year smaller stocks – microcaps, have been one of the best returning segments of the equity markets as we predicted in early 2020, with the TSX-Venture up 50% in 2020 and the Canadian Securities Exchange (CSE) up a staggering 70%.

Many investors have commented that the current market reminds them of the market of the late 1990s, before the dot-com bubble burst.

It begs the question – are we in a bubble?

The Great Inflation

Quantitative easing (QE) is a form of monetary policy in which a central bank purchases longer-term securities from the open market to increase the money supply to encourage lending and investment.

Amidst the global pandemic, central banks have scrambled to cover up demand shortfalls by propping up the economy, which has central banks purchasing bonds and treasuries with their goal of driving up bond prices.

In return for buying bonds, it creates further demand for these bonds which pushes up their price but also lowers their yield. Interest rates are at all-time lows and in some countries the rates are now negative as borrowing costs decline – money has never been cheaper.

With limited policies for central banks to stimulate financial markets, they have universally printed trillions of dollars, which are now sloshing through the financial markets. Greedy participants are prepared to buy any dip and are on the verge of going all-in on the next great stock “tip” – the mad money.

Seemingly, market participants have cornered central bankers in a game of financial chess. With limited options, market participants are speculating on anything that can potentially provide returns as the “cash is trash” rhetoric grows stronger.

The combination of low interest rates and limitless financial stimulus is fooling speculators to indulge in the grand delusion based on the fear of missing out. As the market rallies to unchartered territory, just about every asset class is trending higher – the great asset inflation.

What Can Investors Do?

We are not going to pretend to be macroeconomic experts, nor are we going to foolishly put out some type of “this is the top” recommendation. The reality is no one truly knows. We are reminded of some sage advice from Peter Lynch, who said,

“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”

We adhere to this school of thought and certainly agree. Imagine if you sold all your investments at the beginning of the global pandemic, you would have completely missed out on this massive market rally. The point we are trying to drive home is that it is foolish to try and time markets.

If investors cannot time the markets, what can they do?

We think investors should be preparing for the unthinkable. Although no one has a crystal ball, and unexpected outcomes always occur when they are least expected, we recognize that investor behaviour is a key differentiator in performance. And on that note, ask yourself, how prepared are you to behave when the unexpected strikes?

If the market were to correct by 20% or more today, what would you do?

Do you have strong enough conviction in your portfolio to ride out the storm?

Or are you the type of investor that sleeps better with 20% in cash?

In a game of musical chairs, everything is fun until the music stops. Call it what you want, but this is always the most fun and exhilarating part of the game. Although, keep in mind, that one savvy investor might have said it best,

“A bull market is like sex. It feels best just before it ends.” – Warren Buffett.

Past Observations Are A Helpful Reminder

Last year, we called for a bull market in microcaps in an article we released in January 2020, which can be found here – Click for article.

In the article, we showcased the disconnect between large-cap and microcap valuations and concluded that capital would come down market because of the steep discount. Using both the Canadian Securities Exchange and TSX-Venture as a barometer, which were up 71%+ and 50%+ respectively in 2020 vs 2.2% for the TSX, its evident that money did eventually flow down market.

In hindsight, while our thesis theoretically panned out given the exchange performances, our timing could have been a bit better. Weeks after the article was released, the global pandemic struck sending markets into a manic dip. Again, reinforcing that we cannot expect to time the market.

However, we are drawing on the past because it is still important to understand the type of market we are in and how the trends can help us brace for the future.

Where are we in the cycle below?

Clues from Our Investing Journal

Below are some of our observations and emotional notes throughout the market cycle.

  1. Plenty of supply but low demand. The microcap market was terrible. Stocks were falling, and just when you thought they were close to a bottom, they sank even lower. The type of market where you would enter a bid and hoped the bid would not fill. Of course, the bid would fill, and the stock would immediately go lower. Microcap IPO’s were rare, financings were very hard to close and institutional investors were nowhere to be seen. The sentiment was painful, with no profits to mention.

 

  1. Bottom is finally hit. We barely bought the bottom; we could not have timed it. Our cash was running out and there were other “smarter” investors who purchased shares cheaper than we were – Sometimes as much as 50% to 60% lower. Emotionally, it felt as if every stock we owned was cursed and something was wrong. The good news would barely impact the stock price.

 

  1. Bottom buyers make a profit. The selling supply is gone. Any incremental buying can quickly send prices higher. The bottom buyers are starting to make quick profits with stocks rebounding 20%-30% in short order. The beginning of a new bull market, as the first market participants being to make profits, which greases the gears for the market – Beginning of positive sentiment.

 

  1. Fresh profits are greedy profits. Early investors with newfound profits are hungry to replicate return and begin to rotate capital to other “cheap” stocks. New pools of capital begin making profits as capital starts to churn through the ecosystem.

 

  1. Stock pickers market.With both optimism and profits returning to the markets, it turns into a stock pickers market. New ideas lead this bull market, and the high-flying ideas from the previous bull market are the new laggards. The market is still cheap and one-by-one the good ideas start to get picked off. There are lots of good opportunities and adequate supply available – At this point, the sentiment is slightly positive, and stocks start to “climb a wall of worry”.

 

  1. Emerging market darlings.The new bull markets favorite stocks begin to soar (think ESG). Market darlings emerge and by this point, it is not just the stock picker making money, but retail and some early institutional investors are rewarded with huge financial gains with select companies hitting new highs. Valuations on the market darlings become quite high with large multiples and massive premiums. Examples from this bull market are Xebec Adsorption (XBC-TSX) and Well Health Technologies (WELL-TSX.V)

 

  1. Pulling their peers higher.As market leaders achieve high valuations, they drag their sector peers higher. With valuations rising across the group, new bubbles are formed as the sector becomes “hot”. Investors are chasing returns by betting on the 2nd, 3rd and 4th, best ideas in the same sector. Companies in the sector, irrespective of value, are receiving premium valuations. The sentiment is frothy and buoyant; stocks can rocket higher on good news. Institutional investors and investment bankers have taken notice. Both are coming down market to microcaps. New IPO’s and RTO’s flourish. Investors can’t get enough of the next hot IPO.

 

  1. Speculative Capital. All market participants are making money, and you do not want to miss out too. In this market, the rising tide is lifting all boats. Margin debt levels rise. (Margin debt levels are at record highs right now) Speculative capital is rampant in the market and when stocks rise, it happens more aggressively and quicker.

  1. Mad Money Everything you once thought was cheap, is too expensive. New ideas are hard to find, and valuations are extreme. When you find a new idea, you must pay a premium price and there is almost no supply of stock. New story stocks emerge daily and there’s a blatant disregard for fundamentals. The sentiment is extreme and irrational. The smart money has been slowly taking profits every uptick. Seller’s market.

 

  1. Major Correction/Breaking Point. No one knows it is coming. It can’t be predicted, and it will happen when least expected. The period between a seller’s market and a major correction can take much longer than anticipated. Financings are oversubscribed, regularly occurring.

What We Are Recommending

Since we explicitly outlined that markets cannot be timed, we are trying to draw our readers attention to the concept of preparation.

As investors, the most important thing we can control is our own behaviour. By being prepared for the unexpected, you will be better equipped to make smarter, more rational choices. The worst possible scenario is, being unprepared for when things change, which can force you into quick, foolish, and unwise decisions. Develop an emergency plan before your house catches fire….not when it’s on fire –  humans rarely make smart choices under duress.

What we are recommending is doing the work in advance. And by doing so, you can help to eliminate the emotional disruptions that will challenge your decision making and alter your long-term plans.

One such exercise to do right now is a deep review of your portfolio. Ask yourself, do you like all the companies you own? And how well do you know each company? Now imagine that same company is trading 20%, 30% or even 50% lower, despite the amplified noise, would you hold? Would you be able to BUY shares?

Here is another exercise to think about. Imagine building a new portfolio today, what stocks would you buy and how would you construct that portfolio?

These simple exercises are not that easy. It can highlight some of the biases we have for a stock that is currently in our portfolio. Whereas if we were to construct a new portfolio, would we include these stocks in the said new portfolio? If not, then why do we own them today? We are encouraging our readers to think about their portfolio’s and be honest with themselves, it will help protect your capital and build a stronger portfolio.

Mental exercises, like the ones suggested above, can help us be prepared. If you know what you own and have the conviction to hold the company long-term, the next market phase will be less of a challenge. Moreover, if you have a list of companies you would like to own and have a buy list with what you consider “cheap” or “fair” valuations, you are positioning yourself for success. Being able to not act on emotions, is a position of strength. Know yourself well enough to anticipate how you might act under duress. Plan ahead.

Conversely, if you are in that position where you are questioning your portfolio, or don’t know what you own, you’re in a position of weakness. While you might be foolishly thinking you can handle your emotions now, recognize that even the best investors can be rattled out of a position – eliminate the need to deal with emotions when investing.

2020 was a spectacular year for Canadian microcaps. Many of the conditions that were in place last year are still in place today however many equity valuations are quite stretched. Market volatility can and should be expected. As a retail investor, it’s essential to develop strategies now that will help guide you through any future market corrections. If the markets get chaotic you ideally don’t want to be reacting emotionally while under pressure. Developing a proactive strategy that adequately prepares you for a sudden market correction or other unpredictable event is something you should continuously be working on in the quest to become a better investor.

To your wealth,

Paul and Trevor