Donville Kent Management Extracts from their January ROE Reporter. GLTA
Over the years we’ve been picking stocks and there are moments in time when unexpected opportunities present themselves. Some small and some big. In this edition of the ROE Reporter, we will discuss how we currently find ourselves in a historic opportunity. The current market correction has been better for some stocks and dramatically worse for others. It has certainly been a warranted correction for some stocks and a guilty-by-association sell-off for others. For a selected group of stocks, we are seeing earnings multiples at extremely low levels not seen since 2008/2009, or even all the way back to 1995 for certain stocks.
Cornerstone Macro published the inflation forecast below which projects headline inflation falling from 6.6% in Q4 2021 to 6.1% in Q1 2022. The forecast further predicts that inflation will decrease to 3.9% in Q2 2022, 2.9% in Q3 2022, and ultimately dropping to 1.4% in by the end of the year. This is independent of the Fed raising interest rates and many of the year-over-year deflation numbers already in play (ex. lumber, steel, iron ore, and DRAM prices). All this to say, we believe that interest rate hikes are more than priced into the market. The slowdown in inflation will surprise the market, which should be a positive for growth stocks.
Small caps trading at historically cheap valuation
The most important chart that supports our opening claims is the chart of small cap price to earnings multiples. The chart above was small cap relative to large, versus the chart below is simply the valuation of small cap stocks using Bloomberg’s forward estimates (quarterly data). After taking a look at this graph it becomes quite apparent why we’re referencing this as a historic moment in time. Bloomberg’s data for this index goes back to 1995 and as of January 2022we’re currently seeing the cheapest small cap valuations in that 27 year span. The next necessary step is to see how small cap stocks perform once hitting these low valuations. As the graph shows, the returns over the next 12 and especially 24 months from the lows in valuations are notably strong. Now sitting at the cheapest valuation, it would make sense to expect similar if not greater returns.
The simple reality is that corrections do happen. Recent occurrences include in December 2018 when the Fed was deliberating over a potential rate hike as well as in March 2020 when the pandemic first imploded. In both scenarios, investor panic propelled a major sell-off, only to be followed by a swift recovery. For more evidence, refer to our Fund, which soared by 79% over the 11 months following March 2020.
We view the current correction as setting the stage for great things to come. Given the stellar Q3 2021 earnings announced by our portfolio companies, the historically low small cap valuations, and the irrational punishment of growth stocks, we are definitely bullish on the outlook for our small cap growth stocks. This correction has established the foundation for the next big move.
Our top picks at the moment are GoEasy, VitalHub, Propel, GiveX, Sangoma & NeoGames.