Let’s revisit a risky, but as it turns out, profitable foray into small cap investing I first wrote about two and a half years ago.
The article (from June 2, 2020) suggested individual investors should forgo their usual purchase of lottery tickets: Instead they should buy an equal-weight basket of distressed oil service stocks.
I owned all eight stocks in question. All of them were priced below a dollar a share – cheaper than a lottery ticket – and were valued between seven cents and 60 cents for every dollar of net asset value on the balance sheet (book value per share). These stocks were inexpensive because the environment at the time was grim: Canada was unable to push forward pipeline construction to expand our exports of oil and natural gas, a price war had erupted between Russia and Saudi Arabia and the demand for oil had collapsed because of the COVID-19 pandemic lockdown.
I had no particular insight into how all of this would resolve, so I quoted Baron Rothschild who said that you should buy “when there is blood in the streets,” with the proviso that an investor devote only a small fraction of the portfolio to this risky venture and to buy all eight of the stocks. In other words, resist the temptation to try to pick winners and losers from this sad collection of losers.
One year later (on June 18, 2021), I revisited the package and was pleasantly surprised to discover that the equal weight return from the eight stocks was 171 per cent. The S&P/TSX Composite was up about 30 per cent over the same time frame, so this was a positive environment for the stock market, but the payoff for risk-taking was impressive. After a gain of this magnitude, it would be understandable to take the money and run, but my recommendation at the time was to stay with the package. The stocks were still trading at 53 per cent of book value on average, industry sentiment was improving and there was scope for consolidation within the sector.
Here we are another year-and-a-half later and with the S&P/TSX Composite at around 20,260 – essentially unchanged from the level in June, 2021. How has the group performed? As the accompanying table shows, the average return from June 18, 2021 to Nov. 21, 2022 has been 86.5 per cent, although the spread ranges from minus 1.8 per cent for Titan Logix Corp. to 238.9 per cent for Bri-Chem Corp., which still operates under a “going concern” cloud. For the entire period since June, 2020, the average return for the group has been a stunning 434 per cent.
There are a few caveats to bear in mind when looking at these numbers. First, my original article was targeted at individual investors because, at that time, the market cap of the stocks in this group ranged from $2-million to $208-million. It was clearly not a strategy that could be executed by institutions – which is one reason why it worked, of course!
Second, these stocks were priced as if they were going out of business and I warned that was a possible outcome for several of them. I am frankly surprised that there have been no casualties to date.
Third, only an individual investor in charge of his or her own portfolio decisions could tolerate the negative feedback if this strategy had failed. No third-party asset manager would take the professional and corporate risk associated with having these stocks show up in the portfolio at the end of the quarter.
Now, surely it is time to take some profits and move on, and this time I agree. In fact, I am already in a selling mindset for three of the eight stocks. I recently sold Precision Drilling Corp. as well as some of Cathedral Energy Services Ltd., and may unload Ensign Energy Services Inc. Not because they are extravagantly overvalued as the stock prices straddle book value, but because the market cap is large enough that sell-side analysts have reappeared on the scene and quarterly earnings are being judged against Street estimates. For the individual investor, competing in this environment is like taking a knife to a gun fight, so it is time to move on. Also, the balance sheets for these three companies are leveraging up a little, which is not ideal in a rising interest-rate scenario.
The remaining companies are either statistically cheap or have strong and liquid balance sheets, which may make them attractive takeover candidates. Titan Logix, for example, has a market capitalization of $16-million while the balance sheet at Sept. 30 shows $12.8-million in cash and short term investments, plus another $1.5-million holding in Bri-Chem shares. The company markets a line of fluid level gauges and controllers for mobile tanker trucks with a significant technology content. Revenues have flat-lined for the past few years as a result of inventory overhang, but the most recent quarter shows an encouraging rebound. Essentially you are buying the company for the cash in the bank and getting the technology for free, so I am more inclined to buy than sell this holding.
Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.
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