5I Research Inc. CEO and majority owner Peter Hodson describes why he invests in small cap stocks and gives some guidelines he’s followed to make money investing in these companies. He also explains why he avoids resource stocks and provides five stock picks, many with significant insider ownership and one that recently raised its dividend.
SmallCapPower: Today, we’re pleased to welcome Peter Hodson to the SmallCap Power studios. Mr. Hodson is the majority owner of 5i Research, which provides independent, conflict-free research on investments such as stocks, funds and IPOs. He’s also the former Chairman or Sprott Asset Management LP.
Peter: So, I’ve been in the business now for about 30 years, I’m getting kind of old and my last job was at Sprott Asset Management where I was the Chairman. I’ve been in the business and one of the things that I didn’t like about the business was all the conflicts of the industry. Analysts are conflicted, they’re trying to get you to buy their stocks so they can make a deal. Fund managers, of course, they’re getting paid a fee for taking your money. So, they’re conflicted in terms of what they can and can’t do. Corporate bankers, we don’t even want to talk about them. They’re always trying to raise money. Traders are getting a commission and your sales person is getting a commission.
In the industry, everybody giving you advice has got another agenda, they’re trying to make money off of you. I really just didn’t think that was great for investors and so, I thought well, why don’t I try and eliminate that with 5i Research and just give you a service where we’ll give you an opinion? We don’t care what you do with that opinion, we don’t make any money if you buy a stock or sell a stock, we don’t manage money, we’re not doing corporate finance deals. I did some early-stage research and everybody thought, “Well, that’s an interesting idea. Good luck with that,” kind of thing. So, when I started off, I really didn’t know what to expect but because everyone’s had a bad story in the industry, everyone’s been ripped-off for lack of a better phrase. The response was just phenomenal and I suddenly had this big business that I had to deal with.
It’s been very rewarding personally because now, we’re actually helping people. We’re not trying to take their commissions, we’re not trying to get all their money. We offer a service, you can take it or leave it. And we’ll give you our opinion based on our staff and our experience, and if you make money, that’s good for you. So far, it’s been a lot of fun.
SmallCapPower: Market crashes are an unfortunate part of investment cycles, but can you elaborate on why you think that this most recent one was particularly unusual?
Peter: Sure, I guess the August 24th crash is the main event there, when the Dow went down 1000 points in a matter of minutes. I guess the big thing there is it wasn’t that bad if you looked at it from a percentage point of view. It actually didn’t even hit the Top 20 in terms of market declines and percent. A thousand points is a big number, it catches a lot of attention and the violence of the decline was very, very pronounced. But I think it was unusual in the fact that China has been slowing down more or less for four years. The Fed has been talking about interest rates going up for seven years. None of this was new and it just kind of all exasperated on one day, and everybody started to worry at the same time.
Like every crash that I’ve ever seen and probably every crash in the future, I think people were selling just because it was down. We were talking to clients and they were saying, “Should I sell?” It’s like well, what’s different? What exactly is different on this Monday versus last Friday? There really was nothing new at all. Certainly, China’s currency devaluation scared people but currency devaluation, as you probably know, has been around for a long time and ever since the Crash of ’08, countries have been devaluing currency. It was unusual in the fact that the reasoning behind the decline, nothing was new. It just sort of picked a random Monday to go down the lot and exasperate on itself. Of course, whenever the market is scared or whenever it goes down, investors get scared and people were selling primarily because they’re scared. At 5i, we just think that’s not a good reason to sell at all.
SmallCapPower: Are there any lessons that investors can take away from this?
Peter: Well, we’ve been preaching investing for the long term, and we don’t know where the market’s going to go in the short term. Anybody who tells you that they know the market’s going to go down 20%, they don’t know and if you knew, you wouldn’t tell anybody because you could make more money by not telling someone if it was going. They have to invest for the long term and this is very important for small-cap companies. In a market decline, small-cap companies get hit quite hard sometimes and again, their business has not changed but their stock could go down 30 percent. And you have to say, “Okay, why did I buy it? How long am I going to own it, and what’s the risk?”
At 30% decline from before, your risk is actually less of course, because their stock is already gone down. So, you have to remember your time frame and you have to remember diversification, and you really have to not pay that much attention to the media. A market crash is far more interesting to the media than a market rally. You don’t get a front page headline “Market Rallies 500 Points” but you sure get it when it goes down 500 points. Look at the Globe and Mail, the Friday before the Monday crash, if you want to call it a crash. It had eight or nine inch type saying market panic or market decline, I can’t remember what it said. But to me, that was classic. It’s a classic reaction scaring investors, selling newspapers when really not that much had really changed.
SmallCapPower: These past few weeks, have been scary times in the markets. Do we need to experience an all-out capitulation in order for things to get better?
Peter: A capitulation’s great if you have cash. You can pick away at companies that are being given away by panic sellers, or sellers who have to sell because of a margin issue, or other issues. Whether you need to see capitulation, the problem I think is everyone waits for capitulation and they say, “Okay, I’m going to buy when volume spikes up and the market goes down a thousand points.” But as you know, those are pretty rare events and you can get a decline without volume, and you can get a decline without massive capitulation. Then what do you do? Do you wait for the next leg down, or do you buy now and perhaps get involved with more volatility and perhaps buy too early?
Again, you do have to look at the companies in and of themselves. If you have a company and the stock’s at $20 and you think it’s a good company at $20, and it goes to $16 and there’s no news on the company. It’s just the market and there’s panic on the streets, 16’s probably a great company. Maybe it goes to 14, maybe it goes to 12 but in the recovery, whenever that happens, it probably goes to 30.
So, it’s a question of how acute you want to be on your timing, how much do you want to watch volume and how worried you are about the future. There are events in the market where there’s a change in the world, whether there’s much higher interest rates or much higher inflation, or the terrorist events of 2001. Things do change that change the fundamentals but if there’s no change in fundamentals, then that’s when you want to buy those good companies at 20% discounts. You don’t need to wait for the 30% discount.
SmallCapPower: Small caps in particular have taken it on the chin lately, so what’s the value of continuing to hold them in your portfolio?
Peter: That’s where you get the best returns. Again, you have to put in your time and you have to have a long-term time frame, but a small company, just because of pure math has a much better ability to double, triple and quadruple. Its leverage to single contracts is high, of course. If you’re a $10 million company and you win a $5 million contract, business is pretty good. If you’re a billion dollar company, you win a contract, no one really cares. Certainly, the growth potential is much higher, the growth rates are much higher. We found with a lot of good companies the insider ownership is much higher. These are executives that are watching the company very closely, they’re not making huge salaries because it’s a big company.
So, they have to make the company work and we really, really like when we see that and you have to make sure that the company has a solid business plan. A lot of the times, investors buy a small-cap company because it looks good. It’s not because it is good, because they’ve heard about it or they think it could change the world, or cure cancer, or whatever. Those are the ones that we kind of say why don’t you wait for them to do something that looks good, put in the revenues, put in the profits and then, you can buy it? Sure, you’re going to pay more for it at that time but your risk is dramatically, dramatically reduced.
I think they still serve a purpose for sure, but perhaps things have been too easy for the past five years and investors have kind of forgot about, oh yeah, these things can go down. They can go down 50% on no news, which has happened in the past couple months on dozens of stocks. You just have to remember the basics. You’re buying a small company that may not have public company experience, management may say the wrong things at the wrong time. You may get one seller who wants out for whatever reason and in a bad market, they could push that company down 30, 40, 50% if they really want out on a bad day. Again, you go back to okay, what’s changed at this company? Most of the time, nothing. Most of the time, the only thing that’s different is the price.
SmallCapPower: What do you look for in a small cap stock, and what are the main indicators that you take into consideration?
Peter: One of the best things, and it’s quite easy to do obviously, is to look at revenue growth. We’re of the view that if a company cannot grow revenue, then really, what’s the point of even getting involved? If you can’t have more in sales than you did last year, clearly, nobody is caring about your product or service. You need to have at least some basic growth. Beyond that, eventually, a company’s got to make money. We don’t expect a small company to make money on Day One, but you have to have that road to profitability so that any loss has to be decreasing as time goes on. We love to see insider ownership as we’re talking about. If a company is owned 50% by the managers, at least we know they’re going to give it a good shot if their entire net worth is tied to that company.
We like to see rising cash flow, of course. We like to see a very high Return on Equity. Again, in the early days, you don’t always get this, but it has to come in eventually. And ironically, one of the things we really like to see is a company whose share price is going up. We’re far more interested, by far more interested in a company whose stock has doubled than one that’s gone down 50%. The reason for that is it’s a company that is getting attention. So, someone else likes it. You already know something, you’ve got friends buying with you. It doesn’t mean it’s perfect, it doesn’t mean you buy it right away, but it means you’ve got friends along the way who are going to support that company.
They like it enough to buy it, maybe you should find out about that company. Ironically, that’s probably one of the best strategies we could recommend, is look for companies that are doing well because they’re usually doing well for a reason. You can find these little gems that no one’s ever heard of, yet they’re buying and if you look at it, you look at the fundamentals and go, “Wow. They’re really doing well on a fundamental basis. I want some of that,” and that’s worked out very well.
SmallCapPower: What sectors do you like at this time and can you share with us a few of your top picks?
Peter: At 5i, one of the things we did right was we kind of avoided resources when we started up four years ago. Resources take a lot of effort, you have to go to some mine in Brazil, and go down into the mine and see if the gold’s there. We’re a small company, we’re not going to do that. So, we said forget about that. Worked out really well and from a sector point of view going forward, there’s really no need to go into resources just yet.
You’ve got an over-supply of oil, you’ve got gold that refuses to go up. Even in a crisis, you’ve got a financial crisis, and a China crisis, and gold doesn’t do anything at all. So we’re sticking with technology companies, industrial companies, the bread and butter companies, things that are made, companies that provide a service or make things. Also, we still think the biotech sector has got a pretty good run ahead of it. We’ve had some really good success in Canada once again, and there’s a few companies that are up and coming in the sector that we’re starting to look at.
SmallCapPower: What sectors do you like at this time, and you share with us a few of your top picks?
Peter: Absolutely, in the industrials, one of our new coverage companies is AirBoss of America Corp. (TSX: BOS). Here’s a company that’s been around for 15 years, and I don’t think they’ve issued equity for at least 10 years. Management owns a big, big chunk of stock, and the stock is trading at about 20 times earnings and they make rubber compounds, basically. They’ve got some military business, they’ve got some consumer business, they instituted a dividend a few years ago and things are going very, very well and their earnings growth rate is quite, quite high. It’s now a $400 million or $500 million company and it’s starting to get attention. I think the stock is are up 80 or 90% as we speak today, but a lot of people have never heard of it.
They’ve got operations near our office in Cambridge and Kitchener, and we just love the fact, and I should have mentioned this earlier, the fact that they don’t issue equity. Another example would be Exco Technologies Limited (TSX: XTC), it’s an auto maker. Now the sector, you can talk about interest rates and globalization, things like that, but here’s a company that they raised their dividend 25% in January. Earnings growth has been phenomenal, they’ve got a nice, little niche and they’re picking away the business that the big players are skipping. They’re small enough, so a $400 million contract is very significant to them, where Magna just might not care.
In the biotechs, Knight Therapeutics Inc. (TSX: GUD) is one of our favorites, and it’s completely and totally a management call right now. Here’s a management team that sold Paladin Labs, I think for a billion and a half dollars. The management team sat back, they went golfing for a couple of days and said, “Well, this is boring. Let’s create another company.” So they formed Knight Therapeutics, they raised close to $500 million, and they’ve started to make really nice acquisitions of early-stage technology in the biotech field. You’ve got a management team where the CEO owns 24% of the company, and he’s not doing it for the money. He wants to be a company builder and everything he’s done so far, the management team that’s done so far, has been a success and the company’s not that old. It’s only a couple years old.
Just a pure management bet, but 10 years from now, you’ll be talking about Knight as we’re talking about Valiant and Concordia today. It will be one of the ones of the future. I really like what it’s doing, and I really like the fact that they’ve got a ton of cash and so, in the market decline, that stock didn’t really go down a whole lot. Another one that’s very similar, it’s actually not in the sectors we talked about is Currency Exchange International, Corp. (TSX: CXI). Here’s a company that does currency transfers, facilitates foreign exchange for companies and the management team owns a big chunk of stock. Again, you’re starting to see a theme here. They own a big chunk of stock, the company has cash in the bank, there’s no debt, they’ve applied for a banking license, which will improve their earnings and improve their margins. But this is a company where the management team sold their prior company in a very, very similar business for more than a billion dollars a few years ago.
Again, they sat around for a couple of years and said, “Okay, we’re bored. Let’s form another company.” They’re doing kind of the exact same thing, the exact same strategy, they’re gaining market share. Earnings growth has been fabulous. It’s a $200 million company, so it’s a little bit smaller right now but again, we expect really, really good things from this company. Back in IT, there’s The Intertain Group Limited (TSX: IT), which is a gambling company.
We started following Amaya very early, about $2, and Entertain is now eight times earnings. It’s been beat up a lot in the decline but the earnings growth is there, and they’ve done a good job so far. The sector is a little bit wonky right now. I guess there was a few public companies that came out, they didn’t do so well. Investors maybe were tired of the sector overall, but it doesn’t change the fact that Entertain looks pretty good for the long-term future.
Host: Thanks for taking the time for today’s interview Peter.
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