Donville Kent Asset Management commentary for the month of July 2024.
The fund finished 2023 well and returns have continued into 2024 with the DKAM Capital Ideas Fund returning 34.59% for the first half of the year. Portfolio companies are performing well, and the macro environment is playing out as predicted. Based on recently reported data points, we thought it would be appropriate to re-evaluate where we are in the cycle.
Investor psychology has been interesting to watch over the past 10 months. Small caps hit record low valuations this past October. This segment of the market was the cheapest we have seen and the cheapest relative to recent history. For us it was frustrating as most of the companies we are invested in were reporting record revenue and record profits. Then in November the tides began to shift mainly due to slowing reported inflation. Rising interest rates were the main factor that pulled these stocks lower in 2022-2023 and at the end of the year this headwind started to show signs of receding. As the calendar turned to 2024, the direction of inflation, and in turn interest rates, started to become more and more obvious, which piqued more and more interest into the small and undervalued companies. Countries like Switzerland, Mexico, Sweden, Canada, and the European Central Bank have already announced interest rate cuts this year but the consensus we’re hearing from the largest cohort of investors is that they are waiting for the US to cut rates at least once before they are convinced.
Last Thursday all of this stepped up another level. The inflation print was slower than anticipated. Employment numbers continued to weaken which led to one of the largest reversals of large versus small cap relative performance in history. Below we will show why we believe these past 10 months are just the start of the next 5–6-year bull market for small caps.
Interest Rates
We continue to have the strong view that the money that was pumped into the system during Covid combined with the temporary shutdowns causing supply issues were the main causes of the jump in inflation. Both of these phenomena have played out and are back to pre-covid levels. The 3-month annualized rate of Core CPI fell from 3.3% to 2.1% and the 3-month annualized Core Services fell from 4.2% to 1.3%, which is the lowest print in over 3 years. Alpine Macro phrased it well, “The proverbial “last mile” to the Fed’s 2% inflation target could turn out to be a sprint.”
Reported goods inflation is already negative and China continues to export deflation, but labour costs and shelter have been propping up the reported CPI number. The two charts that give the best outlook on inflation are Unit Labour Costs and Shelter CPI.
Shelter accounts for 30% of the CPI basket. This includes house replacement cost, mortgage costs, and rent. In Canada, mortgage interest costs rose 23.3% and make up 13% of the shelter basket. The issue with this calculation is if you raise interest rates, you raise mortgage costs. I.e., if the rest of the basket is already at 2% and under control, raising rates actually increases reported inflation in this situation. As you can see from the charts, unit labour costs and new tenant rent amounts support the notion of a continual decline in reported inflation.
The Fed has a dual mandate to promote maximum employment and stable prices. As inflation increased, they raised rates in order to stall the economy and lower inflation.
Powell (Fed Chair) was quoted as saying, "We are well aware that we now face two-sided risks," and can no longer focus solely on inflation, Powell told the Senate Banking Committee on Tuesday. “Prices now show signs of resuming disinflation trend… Reducing policy restraint too late or too little could unduly weaken economic activity and employment.”
Pre-Covid inflation was declining since the 80’s. The main factors being demographics and technology improving productivity. US births declined in 2023 to their lowest level in more than 40 years, continuing a two-decade trend of Americans having fewer children. The one question we would pose is what is different now than the environment pre-Covid that led to declining and low interest rates in the first place?
That’s enough about inflation and hopefully this is the last time we cover this in detail, but it is important as a driver behind the beginning of the next cycle.
Cash on the Sidelines
Money has poured into cash-like investments since the Fed began raising interest rates. The chart below shows money-market funds at a record $6 trillion. 2
There was a similar phenomenon in 2000-2001 and 2008-2009 as rates rose. The important investment implication being, as rates declined in the subsequent years, the investor faced shrinking returns on their cash and redeployed that cash into the market which drove the next cycle of the stock market. We foresee a similar logical shift which supports our thesis of declining interest rates leading to the next cycle in small caps.
Valuations
Not only are the valuations still extremely attractive (more attractive than the 2009 stock market bottom where we reference specifics here, but they are off the charts better value versus large caps at the moment. Obviously, many of the largest cap stocks are great businesses with good growth, margins, and rock-solid balance sheets. But an investor doesn’t need to sacrifice growth, margins, and balance sheet strength in order to invest in small caps. Yes, the main small cap indexes are full of “garbage” which include companies with too much debt, thin to no margins, or simply surviving on hype. Roughly half the index is unprofitable. However, large successful companies start as small companies and there are more than enough right now to own in a concentrated portfolio. We will be highlighting some of these companies in our July newsletter which comes out in a couple of weeks
Other Topics
On June 25th Canada increased its capital gains tax. This was covered well in the news and the only reason we’re bringing it up now is the impact it had on some of our investments. We received a few questions regarding some weakness in stock prices leading up to June 25th, especially of those stocks that had done very well. Most of these names have rebounded well in July and we’re only noting here to help our investors understand the price action.
Jason was recently on BNN (HERE). We received a few questions regarding the valuation metrics Jason quoted on the show. When he quotes valuations, he is referencing Cash Earnings. There are a few intricacies to this but the main point being Reported GAAP EPS usually isn’t the proper measure of profitability. As Buffett says "So sanctified, this worse-than-useless 'net income' figure quickly gets transmitted throughout the world via the internet and media. All parties believe they have done their job -- and legally, they have." “GAAP earnings are, in my mind, no less flawed than EBITDA”
The flaw comes down to the very strict accounting rules that don’t treat assets correctly. From day one of the fund, we have measured profitability in terms of what we call “cash earnings”. We aim to evaluate a business on how much cash they generate and how much can be re-invested into the business at high rates of return. Companies like Constellation or Vital Hub, may look expensive if all you’re looking at is reported GAAP EPS.
If you would like a more detailed explanation, please feel free to reach out.
Summary
The main takeaway for us is that many are short-term focused and missing the forest for the trees. We believe rates have peaked and we’re just starting to see capital roll back into small caps. We believe we’re in the first year of the next 5-6 year cycle for small caps and we are currently seeing the best growth to value trade-off in our fund’s history.
Please reach out directly if you would like to discuss investing in the fund, any of the points supporting our economic views or specific companies. We enjoy diving into the details.
J.P. Donville & Jesse Gamble