Recognizing small cap opportunities (original)

On December 22, 2000, a brazen mid-day art heist took place at the Swedish National Museum. Three heavily armed men walked in and removed three paintings – one by Rembrandt, the other two by Renoir, one of which (Conversation with the Gardener) is shown above. The men had planned the robbery to the most minute detail, and had created other diversions in the city to distract police. Once they had secured the paintings, the men found their way to a waiting motorboat and proceeded to vanish. 

By all accounts, the robbery was perfect, but there was one nagging issue. The paintings were valued at approximately $30 million US dollars, but the value of art, unlike gold or diamonds, is very specific. A stolen painting cannot simply be sold on ebay, and many people wouldn’t place a high value on it because they simply wouldn’t know what they are looking at. In order for a particular piece of art to have monetary value, one must be able to validate three things: authenticity, history of ownership, and legal title. If one of these is missing (or cannot be determined), then the value is gone – as is the opportunity to recognize a handsome (criminal) profit.  So, this combination of factors meant that the paintings were valued at $30 million – but not in the hands of the criminals. Eventually, all of those involved in the heist were caught and charged, and the paintings were eventually recovered. What first appeared to be a sure-fire opportunity was nothing more than a mirage. 

Fortunately, the investing universe is not quite so demanding, and most people can recognize the opportunities presented by various companies. But when it comes to the Canadian small cap market, there are more than a few situations where investors aren’t sure about a potential opportunity, and are unsure about what brings value to a particular company. This post deviates from our usual theme of profiling a company we have invested in, and instead takes a look at two very different companies currently trading on the TSX Venture. Both have provided opportunities for their respective investors to profit, but in very different ways, and in different time frames. While you won’t have to be an art buff to have an interest in this post, rest assured that for one (or both) of these companies, beauty is in the eye of the beholder.

What is value exactly ? Merriam Webster defines value as “a fair return or equivalent in goods, services, or money for something exchanged”, and as investors, we can interpret this easily. For instance, if one purchases shares at $1.00 and expects a fair return, then the sale of those shares at some later date at a price in excess of the purchase price (and hopefully in excess of risk free rates) would constitute a measure of value. But, as we all know, we are looking for returns above and beyond “normal”, as investing in small caps can be a risky venture. 

So, in the universe of investment, the ultimate value that one derives from the purchase of stock can be derived by a sale of those shares, dividends from those shares, or a combination of the two. On the surface, this sounds pretty straightforward – buy the shares, collect the dividends, and/or wait for the price to move up. The tricky part is recognizing the value in a particular company, and then, validating the specific requirements to ensure that there is value. Without these, there is the risk that we are looking at a “forgery” – an investment that leads us to believe it will be valuable, but ultimately ends up worthless. 

Does the chart signal opportunity ?  While I don’t consider myself an “expert technician” by any stretch, I do believe that charts have their place in the investing process. If nothing else, they communicate market sentiment about a company, and provide some indication of volatility, even if it is in the rear-view mirror. The two charts below are a snapshot of our two respective companies, which I have re-labelled with new symbols, “BORE” and “OPAQ” respectively. If I used the actual symbols, this process would be a lot less interesting, and rest assured that the real identities of the companies will be revealed – in time. 

The first thing that becomes apparent from these charts is that the symbols provide a fitting description, as one chart puts one to sleep, whereas the other offers few clues as to future success. BORE appears to have zero volatility, having traded almost in a straight line. On the other hand, OPAQ exhibits more volatility, but has also traded sideways for years. More recently, it appears that both are trading at or below the various moving averages, suggesting future weakness for both. At this point, it’s probably fair to say that while a picture is worth a 1,000 words, the words provided here are inconclusive at best. With this in mind, we dig a bit deeper into the financials. 

The details of the financials provide a better picture.   With the technical picture being somewhat murky, we defer to the financial statements to provide some better clues. Rather than dissecting (and discussing) multiple years of financial statements at length, we boiled down some key information into two comparative tables (below), which provide us some context on why the two charts look the way they do: 

These numbers explain a lot. BORE is the model of consistency. Revenues are generally flat, but it appears that the company knows what it’s doing, as gross margins are consistently around 45%-55%, and the company is always cash flow and earnings positive. Additionally, over the 7 year period shown, the company, which has a market cap of around $22 MM (Canadian dollars) has provided no less than $17.8 MM in dividends, or about 80% of the market value of the company. To put this into perspective, in 2013, when BORE had its worst year, it traded around a high price of $3.00 and returned a $0.30 dividend to investors – a 10% yield. This sort of performance explains the lack of volatility in the chart, as shareholders have recognized the value of a company which can execute its business plan consistently and return capital, year after year. Because of this consistency, BORE hasn’t raised capital in years, and the share count has remained flat, meaning no dilution for existing shareholders. 

On the other hand, OPAQ is a cash burning machine. Share count has more than doubled over the same period, and it is difficult to discern any trend when it comes to gross margins. Revenues have exhibited some consistency, but net income and cash flow have been negative in all years. There is precious little to get excited about here – the numbers are simply ugly and do not inspire confidence. While the chart provided an inconclusive picture, the financials indicate one area of success – the ability to consistently increase shares outstanding. 

These trends are further highlighted when one looks at the Enterprise value / EBITDA ratio (EV/EBITDA). This ratio is particularly useful because it takes into account a company’s cash and debt levels, and thereby provides an understanding of not only value, but risk. For instance, a company with a market cap of $10 MM and EBITDA of $2 MM would appear to be attractive, as the EV/EBITDA ratio (excluding debt) would be 5x, implying that a purchaser of the company could “buy” $2.0 MM of EBITDA for only $10 MM, a 20% return.  However, if the company is also carrying $25 MM in debt, the EV would increase to $35 MM, and the EV/EBITDA ratio would be much less appealing at 17.5 times EBITDA. This highlights the fact that the debt obligation makes the investment that much more risky, and suggests that the return is closer to 6%. For the sake of simplicity, the market price at year end is used for the calculation of Market cap and Enterprise value. 

Again what becomes immediately apparent is how the EV/EBITDA ratio of BORE falls within a tight range of 5 – 7, suggesting that despite the fact that it has returned a significant amount of capital to investors via dividends,  investors have yet to bid up the shares to lofty heights. By comparison, the EV/EBITDA ratio of OPAQ is always negative, given that their EBITDA is always negative, and the ratio shows wild swings – which, as you may have noticed, is where the rubber of our story really hits the road. 

Recognizing the two opportunities. At this point, we have explored a common theme, and have come to what appeared to be a clear conclusion. One company (BORE), although offering up little in the sense of “excitement”, provided investors with clear clues. While the chart didn’t immediately scream opportunity, it did signal “lower risk”. An investor who was willing to roll up his or her shirtsleeves and take a deeper dive into the financials would have uncovered the opportunity to recognize a “like clockwork” annual return of somewhere between 7.7% (high price in 2015 of $4.17 with dividend of $0.32) and 14.8% (low price in 2016 of $2.90 with dividend of $0.43). In essence, the ability to “recognize” the opportunity of BORE just takes a little time and effort via a well worn approach. 

The opportunity of OPAQ is, not surprisingly, opaque. The chart provided little in terms of clues, and the financial statements were less than inspiring. Regardless, in 2020, you may have noticed that the Enterprise Value of OPAQ increased by a factor of 8 when compared to 2019. This is where “recognizing the work of art” takes someone who is willing to put in a bit more effort, and who can see how the picture is taking shape as it is being painted. 

Back to the charts. If you were looking closely, you’d have noticed that the previous charts for BORE and OPAQ did not extend through to October of 2020. This was done with intent, otherwise it would have been a lot harder to write this article – and a lot less interesting. In the first part of this analysis, the lack of direction given by the charts compelled us to look (in detail) at the financials, which is how the opportunity of BORE was revealed. Had we included the full charts from the very beginning, we might never have gotten to that point, given that the OPAQ chart would have gotten all the attention. 

Below are the two charts of BORE and OPAQ again, but this time they begin in January of 2020 and end as of October 23rd, 2020, the date that this article was penned: 

Here we see the two charts again, but this time there are some distinct differences. First of all, it is clear that while BORE keeps doing what it does best, the chart is not markedly different than the prior one. Since this time period encompasses COVID, we see the price bottom out in March and April of 2020, but then it recovers nicely and comes right back up to where it was. Anyone that purchased BORE during the depths of COVID will be doing very well. Going forward, a purchaser of BORE during the “COVID dip” will be realizing dividends of (on average) $0.30 annually for the foreseeable future, on a purchase price under $3.00 and potentially as low as $2.50.  That equates to collecting a yield between 10% – 12%, which is pretty good if you ask me. Additionally, it stands to reason that at some point the market might actually notice, and BORE might be acquired at some future date, at a premium. 

That being said, as enticing as an ongoing 10% yield is, there is no denying the opportunity that is now clear that OPAQ has provided. Shareholders who purchased OPAQ and held it for the longer haul have made very, very significant amounts of money. To be specific, a small retail investor that would have invested $5,000 in OPAQ at an “expensive” 2019 price of $0.70 could have realized a total pre-tax gain of approximately $38,000 had they sold close to the peak 2020 price at $6.00. Even at the more recent price of $3.50, an OPAQ investor would have a pre-tax gain of $20,000. Investors who were patient enough and invested earlier (at lower prices) would have held longer, but would have seen some even more extraordinary gains. 

Getting into the depths of the chart. Just as we “waded into the weeds” of the BORE financial statements, we now have to wade into the weeds of the OPAQ chart. If nothing else, it is clear that these two “artworks” are substantially different. If one were looking at a classic sculpture, it wouldn’t make a lot of sense to try & determine whether or not it was an oil or a watercolor. In the same way, it’s clear that reviewing the charts, not the financial statements, will help us better understand the OPAQ opportunity. 

There are two significant things worth mentioning about the OPAQ chart, both of which we will discuss in detail. 

First – what are all of those red dots ? We have all seen the movie where our hero, cornered by villains, jumps into a river to escape. We watch intently, waiting for our hero to surface, but they never do. Death seems imminent, but at the last moment it’s revealed that he (or she) had a hidden source of oxygen – an old water bottle found at the scene provides just enough air to allow them to swim, underwater and undetected, to safety. 

While this example is fairly dramatic, the reality of small caps is slightly less dashing. Companies, large and small, depend on capital to keep themselves afloat. Lack of capital is not unlike asphyxiation – the company will die, either quickly or slowly, if capital isn’t available. For large companies, this is mostly an academic issue. As horrible as the market landscape might be, Enbridge will probably still be able to tap debt markets or issue shares. In the example of our two companies, one of them (BORE) creates more than enough capital from operations, and is able to return excess capital to shareholders. It’s clear that BORE doesn’t need any other sources of capital.  But for OPAQ, the story is different, as it is far from self funding. The ability to issues shares is key to the survival of OPAQ, and an inability to do so would have meant a slow death a long time ago.  

On those charts, along with price, volume, and moving average (MAVG) lines, one can see a scattering of red dots. Each one of those dots represents what is defined as a “non-standard press release”. For instance, a standard press release might be: 

• Announcement of quarterly or annual financial statements
• Dividend announcements
• Announcements about appointments of Directors or Senior management
• Early warning reports
• Share buybacks or notices of private placements
• Notices of annual meetings

Therefore, a “non-standard” press release is something that deals with none of these, and is usually an announcement of “ongoing potential contracts” or a “comment on unusual stock trading activity”. The difference in the two charts is striking: on the BORE chart, you have to look hard to see when the press releases occur. In the 46 month period from January 2017 to October 2020, BORE issued a total of 5 non-standard press releases, 4 of which were related to COVID. On the OPAQ chart, there are so many, they sometimes obscure the MAVG lines. During that same period, excluding all “normal” press releases that one might expect, OPAQ issued 116 non-standard press releases, approximately 2.5 for every month of the year. 

These press releases have purpose: they keep OPAQ first and foremost in investors minds. We are all familiar with the idea that if one hears something often enough, it becomes accepted, and this is not lost on public relations departments. You will recall that the two companies were strikingly different when it came to total shares outstanding – one company (BORE) had issued virtually no shares, while the other (OPAQ) had more than doubled total shares outstanding since 2013. If a company is consistently issuing shares, it is a good idea to do so at the best price possible. By maintaining a consistent flow of communication, it ensures that the company never totally falls off investors radar, and for those investors that are already closely following the company, it provides reassurance that all is going well. In the absence of cash flow and earnings, good communication ensures that the share price never tanks too badly. The fact that the share price never gets “too low” means that even while OPAQ is diluting the existing shareholder base, it is at least mitigating this process to some degree. Additionally, this ongoing communication has another important function.  At some point, one of the press releases (or a combination of press releases and other events) will eventually provide a catalyst, perceived or otherwise, causing momentum to change – which brings us to our second point. 

Second – we need to view a smaller timeframe. The 2017-2020 chart, while it clearly shows what “has happened”, needs to be distilled into a smaller timeframe so that we can look at it “in the moment”. We need to bring ourselves back to when the opportunity was unfolding to get a better sense of what was happening at that time. To do this, we take a look at two OPAQ charts (below), both of which encompass the first 90 trading days of 2020. We look at these in detail, as we know that not much was happening in January and February of 2020, but things suddenly took off not too soon afterwards. 

This first chart is typical. We can see that OPAQ is trading below almost all MAVG lines in the early part of the year. There is a flurry of press releases, beginning in late January, the price dips when COVID is announced, and then the price begins to recover. From the middle of March through to 3rd week of April, the price strengthens, but the improvement in volume is less dramatic. We get the sense the share price is improving, but it lacks conviction – until the price and volume spike in late April, at which point we would be committed to buying in at ~ $0.70 or higher, as opposed to the $.050 – $0.60 range. In essence, it would be nice to have some more fulsome information prior to the spike in volume. This brings us to our 2nd chart, below. 

This chart is similar, but different than the prior one. Like the prior chart, price, MAVGs and press releases are apparent. But the difference we see here is that the bars are no longer measuring volume – we are now quantifying retail investor chatter – essentially, the daily volume of investor discussion. 

For a company such as OPAQ, momentum and technical factors outweigh fundamentals, as we have seen. In this chart we can see evidence of growing investor “chatter”. Measured by the 30 day average of investor posts about OPAQ, we can see that interest in February is building. For example, in early February,  the 30 day average of posts is >15/day as compared to around 10/day in early January. The volume of posts level off a bit during the COVID announcement, but then pick up again in early April, then more in late April, and then one can see it pick up significantly in early May. From the period from mid-March (when COVID is announced) through to the 3rd week of April, we see chatter clearly trending upward. Every day, investors were posting and talking more about OPAQ. This information, in conjunction with all the other information we have, provides that extra bit of confirmation that sentiment is likely to swing significantly in the coming days and weeks. As we know, an investor that would have gone long on OPAQ any time from late March through to the latter part of April would have done very well, as they would not have waited for the “loud” signal of the price spike on April 30th, which drove shares over $0.70. Once the shares were in full “rocket” mode, daily posts kept growing, sometimes exceeding 400 per day. 

The rest of the OPAQ story is history at this point. While the shares peaked over $6.00, they have come off their high, but are still significantly above their early 2020 prices. The long term OPAQ story has yet to play out, and investors who commit capital today are, for better or for worse, buying into some lofty expectations. The market valuation of OPAQ today has much more expectation built into it than it did 12 months ago. For those who bought in early – and held on – I salute you!

In conclusion, there’s probably a few key takeaways that I think are worth mentioning:

• The intent of this post was to point out that opportunity exists in small caps in many different forms, which these two companies serve to highlight. 
• Like fine artwork, for those who value “classic lines”, the TSX Venture does offer up companies such as BORE, the opportunity of which is best recognized via traditional financial statement analysis. 
• For those who prefer something more risqué, one must adopt more technical tools, as the fundamentals will reveal little or no opportunity. 
• The ability to weave in and out of both worlds provides more opportunities to uncover, just as speaking more languages allows you to interact with a more diverse (and interesting) group of people. 
• Lastly, some of the most impactful opportunities may require one to step outside the usual boxes of fundamental or technical analysis. 

I indicated earlier in this post that the identities of the two companies would be revealed, and that is true – just not in this post. I thought it would detract from the post itself if the actual symbols were provided, so the identities will be provided when this article is reposted at a later date. In the meantime, as I always say, these are only my thoughts & opinions. If you have questions or comments, I can always be reached at mark@grey-swan.com.