After chaos; a new stasis with big implications for small cap.

The world economy is gyrating through a chaotic period, out of which should emerge a new stable complex; a new world economic order so to speak. And I think it may look a lot different than the one we are currently exiting. Here are some things that I think will be different based on some conversations that I have had with people close to capital over the past few weeks:

Risk is being recalibrated; destroying liquidity for small cap stocks – By their nature small cap and micro cap stocks are defined by their above average or speculative risk ratings by analysts. In a market where there is limited volatility, professional investors seek out higher risk/higher reward investments where they can benefit from imperfect information and market inefficiencies. Often, small cap portfolios have vastly outperformed the indices. Over the past 20 years, fortunes have been made as fund managers, and retail investors, have made bets on small cap growth stocks, and won. With the disappearance of many hedge funds seeking alpha, the market for small and micro cap stocks has largely dried up. Remaining investors are fleeing to “quality stocks” which are Companies with low beta, and low relative risk. In fact, many investors currently find equity altogether too risky and are fleeing to the bond market.

Equity risk capital is becoming scarcer for expansion and growth– As the world economy ultimately begins to recover (many call for the 2nd half of 2009), between $15 and $20 trillion dollars worth of wealth could be destroyed in the financial markets since August of 2007. This represents between $2000 and $3000 for every man woman and child on earth. One of the reasons that the VIX chart is at historical levels is because there is less equity capital and fewer parties trading stock then there were only 1 year ago. It’s like boiling water; when water level is high, the boil seems less violent then when water level is lower. As capital becomes scarcer, stock trading becomes less dense, but more focused on only a few stocks. The volatility scares away capital. Skittish equity capital is much less likely to fund growth and expansion, which is essential to many small cap and micro cap stocks. CEOs are going to need to focus on other ways to fund growth and expansion if they are not cashflowing or if balance sheets are not solid enough to self-finance.

A period of major consolidation for small caps- Without cashflow or balance sheet strength, many microcap and small cap companies are likely to consider being consolidated into larger, stronger entities. It appears that approximately 20% to 25% of small cap companies have adequate balance sheets to fund growth over the next period of time. Those with weak balance sheets and a distance to cashflow will need to conserve cash through restructuring, selling assets, or merging operations with larger players with cashflow and/or stronger balance sheets. For example, of the 260 or so small cap and micro cap technology stocks listed on the Toronto exchanges, only about 60 to 70 have adequate cash to execute plans. Only about 30 stocks have excess cash and consistent cashflow. These Companies are likely to emerge at the top of the food chain among small caps, although they will still not attract liquidity if they remain small.
Size Matters: Even among the top 30, it is likely that they will not have enough scale to attract enough liquidity to increase shareholder value any time soon. Acting reasonably, Managers should look at leveraging their position to consolidate smaller or complimentary operations. Their goals should be to gain the attributes of mid-cap stocks.

Share Price Does Not Matter Right Now- Almost all small caps are down by 50% to 60%. Share buybacks are akin to throwing money in a hole – in the end, if there is no business scale, it won’t matter how many shares are outstanding. Forward-thinking CEOs are using shares to acquire for scale because, for the most part, dilution is relative because all shares are depressed. When the chaos has subsided, with limited equity capital remaining in the market, scale and profitability will be the major attributes sought by investors as they return to the equity markets.

Cashflow Matters- Managers of small cap and micro cap enterprises need to accelerate towards cashflow by cutting expenses while focusing on only what is profitable. Unless self-financed, investments in innovation should, unfortunately, be delayed. Since the tech bubble, analysts have been enamored with recurring revenue stream models for good reason. With long-term contracts, minimum guarantees, and consistent monthly revenue streams, Companies are better able to maximize cashflow potential in a recurring revenue business model. These Companies are highly attractive to consolidators as well.

Cut Losses- CEOs with cash burn and dwindling reserves should take a hard look at assets and preserve shareholder value by considering asset sales, or distressed mergers. This is painful and demoralizing for many entrepreneurs, but as the new world economic order emerges, there is likely to be a serious gap in venture funding for many quarters to come. Responsible managers should consider preserving some shareholder value.

Adapt or Die- Within the Canadian tech sector, there is a possibility that a significant number of venture listed public Companies could simply disappear over the next year or so. The good and the lucky are likely to be acquired or merged, others will be forced to wind down and sell assets. Regardless, it will be a different environment for small cap and micro cap equities by the beginning of the next decade. There are likely to be a lot fewer listings, because many could be taken private, some merged into larger entities, and others simply go out of business. I continue to hear about Management teams of microcap Companies demanding 10x EBITDA or up to 2x sales for their businesses. Reality is likely less than half that – adapt or die.

The Tech Sector Advantage- The tech bubble toughened up the survivors. Notwithstanding the echo chamber that is now the small cap sector; many small cap technology companies have strong cashflow, emerging cashflow, or strong cashflow potential in relatively short order. There are a lot of solid companies among the carnage that, with a few effective moves, can create long-term shareholder value.

A New Era of Innovation- As all of this tumult unfolds, scores of very talented people will be laid off. Without the layoffs of the 1991 recession, we would not have seen the talent available for the myriad of startups in the 1990s that helped spawn some of the giants of our generation like Google (GOOG-Q), Amazon (AMZN-Q), and Yahoo (YHOO-Q). A decade from now, we are likely to see a new breed of giants that were germinated in 2009.

I do not own shares in any of the Companies mentioned above, nor do I receive compensation in any form from the Companies mentioned.

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