The macroeconomic environment has changed rapidly during the past three years and this transformation has lent itself to various areas of the financial markets coming in and out of vogue at an accelerated pace. Small cap equities is an asset class that can be prone to investment fads. I was reminded recently of how quickly an opportunity can change when I saw a headline that a Canadian small cap company called Xebec Adsorption was seeking bankruptcy protection.
Xebec designs, manufactures, and sells systems that produce and purify industrial gases, such as renewable natural gas and hydrogen. In late 2020, the popularity of stocks in the Canadian small cap market with exposure to renewable fuels skyrocketed. This excitement was precipitated by a push for net-zero emission reduction targets and the Government of Canada authoring documents on the potential size of the renewable fuels opportunity in Canada. For example, a document titled “Hydrogen Strategy for Canada” released by the Federal Government highlighted that under a transformational scenario, hydrogen could represent close to 30% of delivered energy by 2050. Companies like Xebec stood to benefit meaningfully in the long-term if this projection came to fruition. Shares of Xebec began to meaningfully discount this future opportunity and in the fourth quarter of 2020 alone, the stock was up 115%! Given how popular the sub-sector was in the headlines, and how strong the short-term returns were, we started to face questions on whether we had vetted renewables-exposed businesses like Xebec from an investment standpoint. Taking Xebec and looking at it from our investment test perspective, we could see that the company had struggled historically to achieve consistent profitability and that future free cash flow generation would likely be years away. Furthermore, given the positive sentiment in the space, valuation was exceedingly discounting a rosy future as EV/Sales reached a peak of over 25x in early 2021. This combination of questionable track record and excessive valuation did not meet our investment criteria. In other words, we stuck to the plan and did not get swept up in a euphoric sub-sector of the market. As the backdrop started to shift with rising interest rates and inflation, Xebec’s profitability, and valuation, were significantly pressured lower. The lesson is that while addressable markets may be forecast to grow rapidly for years to come, many changes can happen in a short period of time to disrupt an investment thesis. Fundamentals and valuation paid still matter, which were borne out in this example. Avoiding opportunities that lack a margin of safety can be achieved by having a consistent investment philosophy.
Source: S&P Capital IQ
INVESTMENTS THAT ‘STICK TO THE PLAN’
A ‘plan’ for a company is otherwise known as a strategy. Just as we attempt to adhere to a consistent investment philosophy, we applaud portfolio holdings that have a strategy that works and the conviction to stick to this strategy despite external influence. As an example, the Canadian Small Cap Strategy holding, Information Services Corporation (TSX:ISV), is the exclusive provider of registry services in the province of Saskatchewan and provides software services to both financial and legal firms to assist with corporate and regulatory solutions. ISV’s strategy is to efficiently operate the registry business in Saskatchewan while pursuing tuck-in acquisitions that enhance the software services offering and extend client relationships. The strategy has been conservatively financed with modest leverage use over time.
In the summer of 2020, Dye & Durham Ltd. (TSX:DND) went public. This business is comparable to ISV’s in that it offers software solutions for legal firms, financial institutions, and governments. However, the strategy that DND employs to grow vastly differs from ISV’s. Both companies pursue acquisition growth, but DND has done so at a feverish pace, deploying over 1.5x its current market capitalization on M&A in the last two years alone. To finance this, DND has leveraged its balance sheet to over 4x Net Debt/EBITDA (as of June 30th, 2022), while ISV has ~1x Net Debt/EBITDA. DND takes acquired businesses, cuts costs drastically, and attempts to implement substantial price increases. ISV’s approach is to focus on the customer’s needs first and foremost. For a period of time in late 2020, DND’s strategy was rewarded by the market with significant share price appreciation. Subsequently, ISV was questioned by investors wondering why the company wouldn’t pursue a strategy similar to DND’s, given the apparent success and market feedback. ISV stuck to its strategy, having seen evidence over time that it works (for example, the company has generated a 7-year return on invested capital average of 35%). As growth-at-any-price fell out of favour in the market, the heady multiples that DND once received have corrected. Since DND’s IPO in July 2020, ISV has now outperformed.
Source: S&P Capital IQ
Having a plan, process, or strategy that has historically proven to be successful is key, but the conviction to stick to the plan despite outside noise takes discipline.