The Canadian Small Cap Equity Markets Are In Crisis

by: Edward Vranic, CFA

(Editors' Note: This article covers micro-cap stocks. Please be aware of the risks associated with these stocks.)

Most equity investors around the world have enjoyed very good returns since the recovery from the 2008 crash, but Canadian small cap equities have still been in crisis. The TSX Venture Composite Index has experienced a steep loss of 60% from over 2,400 in April 2011 to less than 1,000 today and hit as low as 860 late in 2013.

Dozens of small cap companies on the TSXV have de-listed and investors and speculators in Canadian small caps have been badly hurt by the decline. Reviewing the 10-year chart below shows that long term investors in the index have lost nearly 50%; an unprecedented poor performance considering the length of time in question and that the Canadian economy is supposedly one of the most stable and safest economies in the world.

In a worldwide financial crisis it would make sense that the TSXV would decline as it did in 2008. But after a strong recovery that was seen in all markets through 2010 and the winter of 2011, the TSXV turned back downwards to the point where it is once again challenging its 2008 lows. The TSX Composite Index, buoyed by banks, telecom and other large industrials hasn't suffered the same fate as its junior counterpart, but the TSX is only now recovering to the 14,000 level it saw prior to the 2008 crash, well underperforming the larger markets in the United States.

What has been the driver for Canada's underperformance, particularly in its microcap equities? One can point to sector bias for part of the answer. The TSXV is very highly weighted towards energy and material stocks, two poor sector performers despite the relatively strong performance of the underlying commodities. These two sectors alone make up an outstanding 85% of the Index. While the TSXV was once heralded as the place to invest in for junior exploration companies, this complete lack of industry diversification has exposed the weakness of the index.

When we compare the price of oil, gold, silver and other commodities back in 2004 to today's prices, it is disappointing that the TSXV would be at a such a depressed price over such a long term. There are additional forces that are causing this exchange to suffer greater losses than the energy or commodities companies trading on the TSX or in the United States.

One of the major weaknesses I have seen inherent in many TSXV-listed companies is that the management teams act like bullish investors instead of leaders of a business. They become "gold bugs", "peak oil" bugs or "language translation software" bugs and spend too much of their cash too quickly trying to develop their business or acquire land, over-leveraging and overexposing themselves to the price of the underlying commodity.

Explorers spent all their cash buying and drilling into prospective land with the expectation that the larger producers would farm into their projects or buy them out. When commodities markets soured, the focus of the large producers shifted from growth of their resource base to lowering their operating costs and these explorers have been left to fend for themselves with little cash left to navigate through this temporary commodity bear market.

Producers loaded themselves up with debt which in the short term kept equity investors happy by avoiding dilution to the shares, but doing this left very little breathing room for operational issues or negative turns in commodity prices. OPTI Canada is an example of an overleveraged company which was listed on the TSX. Cost overruns at its Long Lake oil sands project saw its stock price go from over $20 to $0.10 as CNOOC acquired the company.

Microcap Canadian companies generally do not plan well for contingencies and when they do, investors become highly critical. A company which I have spoken highly of in a previous article called Fireswirl Technologies (OTC:FRWRF) has delicately balanced its cash needs with reasonable dilution by performing two small private placements in the second half of 2013. These secondaries resulted in about 8 million shares added to the float, or about 18% dilution. The company was heavily criticized by investors who cited a low price for the placements and a lack of immediate need for the cash. I found the dilution to be of reasonable size and the strengthening of the balance sheet to be excellent cash management and contingency planning as the company aggressively grabs market share in the Chinese eCommerce sector. Yet both placements resulted in significant short-term price drops before the stock price recovered. When investors are so impatient and so quick to lay out conspiracies that the company is giving cheap shares to privileged investors, it's no wonder that some companies delay a need to finance until absolutely necessary. By the time that need comes along, there may be no funds available to them under reasonable terms.

While poor cash management, repeated operating losses and over-leveraging can explain the downfall of many weaker TSXV companies, there are many stronger players with good cash management or growing revenues or profits which still sit at or near 52-week lows. I have recently written about two examples. Selectcore (OTC:SLXXF) recorded a profit in its latest financials after several quarters of losses thanks to much leaner operating costs and is actively looking to improve its working capital position. Noble Mineral Exploration (OTCPK:NLPXF) adeptly sold the surface rights on one of its properties for a profit while still maintaining the mineral rights to it and used the money to pay off its debt. Both companies saw a spike in their stock prices on higher than normal volume recently, and both were met with very heavy volume selling in reaction to the stock price pop. Selectcore sits at its 52-week and several year low despite the improving income statement and Noble's market cap is less than the $6.8M in cash it received from the recent sale, not to mention the additional properties and working capital it had prior to the transaction.

Why are these companies that are showing clear signs of improving their businesses also subject to such poor stock price performance and aggressive selling? An interesting article from Equedia Investment Research called "Why the TSX Venture is Failing" makes the claim that market regulatory weaknesses, particularly a lack of the uptick rule, is the driving force that enables certain market players to bully junior explorers out of the market by limiting their access to capital without unreasonably high dilution. I believe that this could be a factor for some listings, while others have more straightforward answer.

I don't believe the bulk of the selling is due to naked short sales. I believe the bulk of the sales are from struggling mutual funds, hedge funds and other institutional players who made bad investment decisions and are in need of cash to cover off redemptions as investors are pulling out their money from underperforming funds. They are generating cash by blindly dumping all of their small cap holdings, regardless of the long-term potential they see in them.

Let's take Sprott Asset Management for example. Sprott is one of the most well-known and respected names in the Canadian fund industry. Yet looking at the recent performance of their equity mutual funds, you will find shockingly poor performances. The Gold & Precious Minerals Fund lost 38.3% last year and has a 3-year average annual return of -28.3%. An annualized 3-year return of -28.3% equates to a total loss of 63% for that three year period. The Canadian Equity Fund lost 31% last year and has a 3-year average annual return of -23.6%. All four of Sprott's equity mutual funds have lost money on average in the past three years along with disappointing recent returns in the Balanced, Bullion, Tax Efficient and Hedge Funds.

Sprott's performance is not atypical from many other Canadian funds but when a respected name like Sprott takes such an unexpected and extreme turn for the worse, people will react by taking money out of Sprott funds and put it into other assets. Especially when Canadians can turn on CNBC and see such prosperity for Wall Street. My Selectcore post proved that it is Sprott responsible for that stock's low price as the fund is dumping its Selectcore holdings for cash. The good news for investors in that stock like myself is that Sprott has a limited amount of shares left to sell.

I use Selectcore as an example that I am familiar with, but investors who follow microcap Canadian stocks should review other stocks they are familiar with and they may come to the same conclusion as I have.

The TSXV has not been all negative for investors. 2013 saw some incredible returns for some companies with growing revenues and/or profits and ones in hot industries. The biggest driver in the rise or fall of a company's stock price may not be tied to the success of its business but rather if Sprott or another fund in decline owns them or not. Once these funds are cleared of shares, the depressed prices of Selectcore, Noble and many others will represent excellent high-risk, high-return opportunities for aggressive investors as the supply of shares dries up and the prices return to some reasonable demand-supply equilibrium.

I refer you to my blog post "Looks Like A Fund Imploded Today" for further evidence of across-the-board selling of stock without any regards to each company's situation. The picture below is a screen capture of the trading on February 5th for the day's top percentage losers.

Does it not appear unusual that there is a 50% loss on heavier than normal volume for so many microcap explorers which happen to have a name starting with the letters R and S? This appears to me to be a trading bot implemented for the purpose of an institution dropping all their microcap names starting with letters towards the end of the alphabet with absolutely no regards to each company's value. If something like this were to happen on the U.S. exchanges where an obvious pattern of selling that was unrelated to company fortunes took place, there would be a lot of demand for an inquiry by the SEC.

This trading is very reminiscent to the trading seen in the middle of the financial crisis in 2008-09 across the globe when there were many individuals and funds selling stock to hoard cash regardless if they were bullish or bearish on the companies themselves. Once the wave of panic was over and the selling dried up, stock prices returned to normal and have continued to climb. The same thing is happening to the TSX Venture for a second time except on a much longer time scale. Considering how high the U.S. market is relative to Canada's market, I believe there is a huge buying opportunity for the stocks on the TSXV which are in the top of their class in terms of financial strength and business prospects. I expect that once these funds have exited the market, the supply of cheap shares will disappear and anyone who held through it all will recover some or all of their money lost on paper and anyone who managed to buy near the bottom will make great returns. For those companies which are low because of weak planning and lack of cash resources, they may recover but they are much more dependent on the commodities market and the merger and acquisition activity of the larger producers.

Disclosure: I am long FRWRF, SLXXF, NLPXF. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.