Am I the only one who feels we might have hit the bottom in Canadian microcaps?
Don’t get me wrong, I’m not trying to make macro forecasts, and this post won’t be about the direction of interest rates. I’m a bottom-up fundamental investor. And at the micro level, a few positive trends have been taking shape, leading to a strong market rebound in November.
Let’s unpack some of those trends.
1. Earnings are strong
The Q3 earnings season is coming to a close, and most of the companies I follow have been posting very strong results this quarter. Whereas companies previously commented on inflation and supply chain issues to justify poor performance, these issues are now in the rear-view mirror.
Despite the TSX Venture being down almost 50% since its peak in 2021, fundamentals are actually solid. As long as you focus on revenue-generating and profitable companies, there’s nothing wrong in most cases.
2. Companies that show fundamental progress get rewarded
More than any time in the last two years, I’ve seen strong moves to the upside in companies that published great results or news in November. Here are a few notable examples:
Vitalhub (TSX: VHI)
Thinkific Labs (TSX: THNC)
Kraken Robotics (TSX-V: PNG)
3. Transaction volume is picking up
This one is anecdotal because I don’t have data to back it up yet. But looking at the charts above, you’ll notice how these stocks have moved on higher than average volumes. And this is happening pretty much across the board.
I’m looking forward to seeing the next set of data published by the TMX Group (the operator of the TSX and TSX Venture) in early December.
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4. Institutional money is coming down the market cap spectrum
Following up on the above point, I believe the increase in liquidity we’ve been seeing is primarily due to institutional money returning to the microcap market. Stocks don’t go from barely trading to millions of $ of volume daily without institutional money being involved.
An interesting transaction also happened on Kraken Robotics (TSX-V: PNG) last week. On Thursday, a large block of 21 million shares changed hands (over 25x the average daily trading volume) for about $10.5 million. A group of long-term fundamental institutional investors bought it. The rumor is that one of these institutions had never bought such a small stock before.
Institutional capital flows can create significant moves in an asset class with meager liquidity. If this is really happening, we could be in for a substantial rerating on some of the higher quality names.
5. Private Equity has put a floor on valuations
At this point, it feels unlikely that the market will go much lower since several companies have been acquired for significant premiums by US private equity firms or strategic investors, and there should be more to come.
If you haven’t read them, I’ve written a couple of posts on this topic: Flurry of Acquisitions and Private Equity Is Coming.
How I’m approaching this market
Based on the above observations, I hypothesize that institutional money will come down the market cap spectrum. They will primarily look for high-quality companies trading on the cheap, which seems like a pretty obvious thing to do.
The $100-300 million market cap range seems to be the right place to hunt right now. In terms of size and liquidity, it’s the best place for institutional capital to enter the space first. Several recent acquisitions have also happened in this size range, which provides an additional shot on goal.
In terms of fundamentals, I would look for growing and profitable companies with low valuations (less than 10x earnings/EBITDA), like Kraken Robotics (TSX-V: PNG) and Vitalhub (TSX: VHI).
Another area of interest would be technology companies with lots of recurring revenues that are somewhere around cash flow breakeven. This type of company is likely a bargain below a 3x EV/revenue multiple since most acquisitions have happened in the 3-4x revenue multiple range lately. A good example would be Thinkific Labs (TSX: THNC).
Once the asset class starts overperforming and most of the good “larger” microcaps have rerated, the smaller ones (below $100 million market cap) should get more love and attention as capital keeps chasing new opportunities.
I’m careful to officially call this a bottom, but it sure feels like we might have turned the corner.
Is anybody else excited as I am about the current market dynamics?
Disclaimer
This publication is for informational purposes only. Nothing produced under the Stocks & Stones brand should be construed as investment advice or recommendations. Mathieu Martin, the author, is employed as a Portfolio Manager with Rivemont Investments. This publication only represents Mathieu Martin’s own opinions and not those of Rivemont. Rivemont may own positions and transact on any securities mentioned in this publication at any time without prior notice. At the time of this writing, the Rivemont MicroCap Fund holds a position in Kraken Robotics (TSX-V: PNG). Always do your own research and consult a professional before making investment decisions.
If you’d like to invest in small public companies, check out this post.