Go Long Quality And Short The Junk [GeoWire Weekly No. 154]

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The big news last week was the Federal Reserve’s decision to slash the Fed’s funds rate by 50 basis points to a range of 4.75% to 5%.

Everyone’s talking about the magnitude of the cut and the implications for the stock market, especially for the Russell 2000 Small-cap Index, where it’s been demonstrated that smaller companies as a whole have more floating-rate debt on their balance sheets. However, they are missing the most important implication related to certain statements made by the Fed Chairman. These statements will have serious connotations for the microcap stocks that we cover in our 1500+ universe.

Among several comments that CNBC journalist Michelle Fox recently contributed to ongoing coverage of the September 18 fed meeting recap, ‘Chair Jerome Powell defends central bank’s decision to go big with first cut‘, she wrote:

“‘We are not going back’ to world of ultra-low interest rates

Federal Reserve Chair Jerome Powell does not expect the era of cheap money to return.

“Intuitively, most — many, many people anyway — would say we are probably not going back to that era where there were trillions of dollars of sovereign bonds trading at negative rates, long-term bonds trading at negative rates,” he said.

“My own sense is that we are not going back to that,” Powell added.

He feels the neutral rate is likely significantly higher than it was back then, although he does not know yet how high it is.”

Of course, I had to chime in with a thought or two of my own in response to her comment:

“This is so super bullish for quality, smaller cap…. I can’t begin to tell you how much. Long quality + short junk in small cap (that’s still around from the easy money days) will be in play for years. Game on!”

Jerome Powell’s recent comments illustrate a consistent theme he has been emphasizing over the past year: the era of “cheap money” is unlikely to return. Since the aftermath of the 2008 recession, as well as during the COVID-19 pandemic, the Federal Reserve adopted quantitative easing and ultra-low interest rates policies to stabilize the economy. Now, Powell has made it abundantly clear that this period, characterized by negative, near-zero or even extremely low interest rates, is behind us.

This was music to my ears. I was somewhat concerned that the bull market in high-quality stocks that began percolating in 2022 could eventually be threatened if the Fed decided to return to an ultra easy money policy.

Make no mistake – we have been pounding the table since mid-2022 that elevated interest rates (if sustained) will lead to a long-term bull market in smaller cap, high-quality companies not heavily reliant on external funding to grow or finance operations. Why? The access to “survival capital” has been closing for lower-quality companies and pump & dumps. 

It’s unfortunate that many investors, especially younger investors, that “fed” off the teet of the market during the 2009 to 2022 low quality bull market, still don’t understand that this period is not and was not the norm. 

I’m incredibly excited that we are finally entering a similar type of normalcy that existed in my first 20ish years as a full-time investor, where GARP-ish microcap investing was in play. Quite frankly, I was able to crush the market, even though I had to suffer a serious setback when the internet bubble blew up, one I was not sure I was  going to come back from. And then, there was 2008! But I will save that drama for another storytelling time.

The best evidence that good times are here for old-fashioned, quality, value investing or whatever you want to call it, is the performance of the MSMqi, the only index that qualifies a stock through a combination of quality and multi-bagger factors.

I’m interested in finding out more about the multibagger traits.

By the way, another great indicator that quality is here to stay, and that low-quality is going to get punished is an index our team created in 2023, called the “Zombie Index”, which I haven’t published anywhere yet. This index tracks the low quality, smaller cap stocks, based on certain criteria.  Here’s what that looks like (negative returns in short selling equate to positive returns on your capital):

.

You can learn more about the Zombie Index in this clip from my Investor Insights Skull Session chat with Deep Sail Capital last week:

In a nutshell, the theme for many years to come will be long quality / short junk. Investors in the microcap space will need to focus on stock-picking.

There’s only so much money to go around in the market, and now, some of that money that was finding its way to low-quality companies during the easy money days is going to continue to make its way into the higher-quality microcap universe that we play in (a trend that began in 2022). 

For well-managed, undervalued microcaps with great fundamentals and a clear path to growth, the current environment could allow them to shine as capital becomes more selective. We also think the environment is fantastic for high-probability turnaround situations, where balance sheet restructurings or small tweaks in business plans put a company back on track for growth.

However, companies that rely heavily on external funding will continue to face headwinds. I’ve written on these bullish viewpoints over the years, so I dug a few of them up, showing that GeoInvesting has consistently been a champion for the resurgence in the leadership of quality microcaps under the right conditions as well as company-specific variables, even giving Canadian microcaps a plug, which, as intimated, have taken a major place in our coverage universe.

• 2022: The Great Head Fake (X Thread)
• 2023: Capitalizing On Inefficiencies: A Reflection on ‘Damsel in Distressed’ by Dominique Mielle
• 2024: My 195.5% Mistake Signals Microcap Value Is Making A Comeback
• 2024: Microcap Bull Market Has Arrived

So this is probably a good time to pivot to three discussions I had last week, one with a peer, the Founder of Deep Sail Capital, and the management of two companies in our microcap coverage universe – Covalon Technologies Ltd. (OTC:CVALF) (TSX:COV) (wound care and infection control products) and Tss, Inc. (OTCQB:TSSI) (data center integration services). Needless to say, it was a busy but fulfilling week, and it took a bit of heavy lifting to have gotten ALL the conversations to you today.

Continue to watch these 3 full length videos.

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