Changes in fund mandates, risk averse brokers, and sellers with itchy trigger fingers
Stockhouse Ticker Trax is equity specific research (Canadian listed and market cap < $300 million) published every Monday to paid subscribers. Our free Friday column may feature companies previously featured to paid subscribers (with a minimum one month delay) or discuss topics of interest to the general investment community and relevant to overall portfolio management.
On Thursday, the U.S. Federal Reserve lit a fire under equities and justified the inflationary reasons (both short and long term) to be bullish on the already high prices of gold, silver, and oil – not to mention several other commodities.
However, even as penny stocks trade near low valuations not seen for decades, we can only move ahead in baby steps with these higher-risk equities.
The past 18 months has seen dramatic changes in the landscape for micro cap stocks (typically valuations under $200 to $300 million) and while the returns can be exceptionally high, the risks and liquidity are the trade-off.
A glaring problem is the overhang of paper that has been underwater for well over a year now and is simply waiting for an excuse to free up cash (marginally higher prices and liquidity). From a Canadian perspective the benchmark is the TSX Venture Composite Index which until recently was down 50% from spring 2011.
The stocks in this index are expected to be the best-in-class so you can imagine how poorly the lower-quality equities have performed. For many the average loss was in the range of 70%!
These losses have been devastating for the corporations, retail investors, wealth managers (stock brokers) and their firms, analysts, and fund managers.
In fact, the poor equity performance of these small stocks has created a dramatic shift in the industry and this is where the real challenges lie ahead over the next year.
When we came out of the economic collapse in Q4/08 and Q1/09, the small stocks generated remarkable gains over the next two years. As a newsletter writer I picked just over 100 companies during that period and lost money on about a dozen while the huge majority gained (on average) well over 100% or more.
While I would like to think the same thing will happen from these current levels over the next year or more, it is difficult knowing what to expect going forward – for the following reasons.
1) The increased buying and liquidity means many stocks must now eat through boat loads of paper that many larger shareholders (funds in particular) have been sitting on throughout 2012 waiting to liquidate. This won’t occur overnight and the challenge is having a strong enough market environment where buying is sustainable and lasts more than a week.
2) Wealth advisors (stock brokers) have seen their industry change dramatically over the past few years. The majority have moved to a fee based system where they don’t depend upon straight commission but receive a percentage of a client’s overall portfolio value. This means they don’t want risky bets because it hurts the advisor and the clients.
3) For Canadian public companies in particular, they have depended upon the brokers for financing and recommending their stock to clients. As junior equities have eroded in value, many who focused on that side of the business have left to pursue other careers or shifted their business model to concentrate on mid to large caps that preserve wealth and keep their clients from leaving due to negative returns.
4) With the popularity of ETFs for almost every aspect of the equity market (including gold exploration stocks), many retail investors have taken the easy route and simply put their money into an ETF fund (similar to a mutual fund). This saves them the risk of being wrong and the effort of doing their own research. The problem is, there are many misconceptions (and risks) with ETFs. Either way, this has pulled a tremendous amount of money away from junior equities.
5) Disposable income has eroded as personal debt levels grow and the expenses of running a home and supporting a family rise dramatically. This cuts into the money that is used to speculate on penny stocks.
6) For the past several years we have seen more and more brokerage firms in the United States prevent their advisors from recommending or even buying penny stocks. This doesn’t impact self-managed accounts through discount brokerages but full service still accounts for a huge percentage of equity trading. This past year the situation has become worse so it removes a lot of liquidity from the junior equities.
7) For public companies (many in desperate need of cash), they have diluted (damaged) their share structure dramatically. Not on the scale you would see in Australia or Asia (where they seem to have no problem with a billion shares outstanding and a three cent share price), but still a dramatic difference for Canadian or American investors.
8) Fund managers always experience turnover and in 2012 the new managers are cleaning house on old positions. Often the first to go are the small stocks and we have seen this hurt the junior exploration stocks particularly hard over the past year (although it has been building for 18 months). Many juniors financed with these funds and they were the first to throw the company under the bus – and still are unfortunately. While many have liquidated their positions throughout 2012, a lot of old paper still exists in the system – and it will take some time to eat through these large share positions. New funds will come to the table but they will be much more selective.
In light of all this, a huge amount of money has been sitting on the sidelines and in typical herd mentality, sector interest can change quickly and last for months.
If a sector rallies, investors pile in when they feel they are missing the bus. Even with all the points I mentioned above, this psychology of the market will never change. It may just be tempered somewhat in overall volume.
My own personal strategy is to employ the same valuation methods I did following Q1/09 but whether they work as successfully in this new environment I am not sure. One would tend to think so (even if the overall gains were less) but the playing field is definitely different than what we have seen at any time in penny stock history.
Either way, speculating on these stocks can be exciting and financially very rewarding. You just need a realistic expectation of percentage gains this next year and the stomach to absorb losses.
I have been researching and buying these volatile stocks for over 30 years now and I still lose money and shake my head in amazement at the dumb decisions some management groups make with other people’s money.
That will never change and the fact you lose money on these speculations will never change. But it only takes a few nice hits to absorb realistic losses and the gains can be quite exceptional.
In addition to this weekend column and the bottom fishing research sent to paid Ticker Trax subscribers on Monday, I also provide free MicroCap alerts throughout the week. These are based upon News or Abnormal Price/Volume Activity on the several hundred stocks we track from our own research, brokerage analysts, or third-party newsletter writers.