Donville Kent Asset Management commentary for the month ended August 31, 2024.
The Fund finished 2023 strong and returns have continued into 2024, with The Capital Ideas Fund returning +10.50% in August and bringing the year-to-date return to +66.9%.1 We think this strong performance is indictive of the start of the next 5–6-year bull cycle for small cap stocks.
Valuations for this segment of the market remain extremely low, even as individual company performance remains strong. Generally speaking, stock valuations don’t predict short-term performance but we’re firm believers that they are appropriate long-term indicators. We wrote a more detailed note on valuations HERE.
As for short-term indicators, we’re currently writing this commentary as Canada announces another interest rate cut, the third in as many months. The rapidly rising rates of 2022-2023, which created a massive headwind for stocks in 2022-2023, has now shifted to a tailwind.
The below chart is a great visual to show how important the direction of interest rates is on stock market returns. The top line shows the stock market performance when the market is in an up-trend and interest rate are falling (the environment we recently entered) versus markets in an uptrend when rates are rising (like in 2022-2023). What we’re trying to show here is how powerful declining rates are on stock performance and this chart illustrates the magnitude of this impact.
We wrote on the impact of inflation and interest rates on stocks, plus where we think we are in the cycle HERE & HERE. We believe with rates declining in most countries, or soon to decline in countries like the US, the tailwind and timing shouldn’t be ignored. Combined with low valuations in small caps and a historic amount of investable assets sitting in cash, we continue to believe the next few years will be strong.
The Fed is expected to meet and cut rates September 18th.
Recent Fund Performance
August performance for the Fund of +10.50% was boosted by ~4% due to the announced acquisition of Givex Corp (GIVX). The deal was announced on August 26th for $1.50/share. We invested in Givex late in 2021 at the IPO and added over time for a realized absolute dollar return of ~67% and an IRR of ~24%. We have sold this position which gives the fund a good amount of cash to invest at what we think is an opportune time.
Reported Earnings
August saw many of our positions report their quarterly earnings. We would like to highlight four investments that reported their quarters during the month.
Zedcor (CVE:ZDC)
Zedcor reported 19% revenue growth, 46% gross profit growth, and 42% cash earnings growth in the quarter. This quarter showed the start of their inflection, and revenues should accelerate quickly from here. We expect close to 30% revenue growth next quarter and over 60% for Q4. What’s even more impressive is that growth should be over 80% for 2025 with management aiming for +40% EBITDA margins.
We have now highlighted this name a few times in our reports so we will just hit on new and poignant points here.
Competition – Over the last few months we have been trying to speak with and get our hands on as many competitors’ products as we can. There are some important points to make when it comes to differentiation.
Service – Many of the “competitors” only offer tower rental, and don’t provide monitoring services. Also most don’t have local service employees, so the customer is in charge of logistics and has to move the tower themselves from location to location as well as figuring out hardware servicing & monitoring. By Zedcor handling all logistics and servicing with boots on the ground, it is helping them gain market share.
Quality – This might be the most obvious differentiator once you see a few of these towers in person. We would qualify Zedcor’s towers as “Commercial” with industry leading quality construction while there are a lot of competitors that have what we consider “push over towers”. An example would be Zedcor equipping their towers with 6 batteries and 3 solar panels that can power the unit for 5-7 days if need be while other competitors need on-site power to hook into or some are only equipped with 1 battery and 1 solar panel.
Access – We have heard that the largest competitor requires 6-9 months’ notice for delivery and want 2–3-year commitments. Some other competitors can move more quickly but there are issues like needing power on-site. Zedcor appears to be matching new unit construction with demand well and offering less demanding terms. In addition, most competitors are regional and Zedcor has now expanded across Canada, into Texas with recent growth, and into Arizona, Colorado and Washington.
From what we’ve found, Zedcor is the only company that offers a quality product, with monitoring services in-house, logistic services and local service, plus availability.
Market Size – An important question is how big is the market for this service? We think what is lost on investors is that this is a “new” technology. Until recently, combining HD cameras, solar power, satellite internet, cloud storage, and artificial intelligence monitoring wasn’t feasible. The overall cost to the customer is less than in-person security, with better results. That is to say, there is a lot of white space in the market. Zedcor is currently at ~1,000 towers and if they continue to expand within their current client base, we can see them getting to 10x the size with a lot of upside considering the 100’s of thousands of potential new client locations (car dealerships, construction companies, pipelines, big box retail locations, etc.).
SSC Security (CVE:SECU)
SSC Security reported 12% revenue growth, all organic. Cash earnings increased 56% as they start to scale both businesses but especially their higher margin cyber security segment, which grew 16% in the quarter.6 This was the company’s strongest Q3 in their history and their outlook is strong. They continue to buy back stock and pay a dividend with a 4.8% yield. We expect organic growth to remain at +10% and they should complete a couple tuck-in acquisitions per year to supplement growth. They are currently sitting on $12M of cash with no debt, and with legacy assets converting to +$10M in cash over the next 10 months (this is on the balance sheet at book value and not market value), so half the market cap is in cash with no debt.
Kraken Robotics (CVE:PNG)
Kraken reported revenue growth of 67% with 113% cash earnings growth.6 They maintained their 2024 guidance which implies 29-44% revenue growth & 28-70% EBITDA growth. They have a net cash balance sheet and mentioned, “The demand environment for our technology solutions has never been better and the opportunities we are seeing in both our defense and offshore energy markets continues to grow.”
We followed Kraken for a long time but decided to invest this year because we believe the business has hit an inflection point. Both revenue and earnings growth now look more stable and reliable plus there is a lot of upside as many of the customers are considerably ramping up production. One example would be Anduril Industries, a defense company recently valued at $14B that is quickly becoming the leader in unmanned defense technology.
Anduril was recently awarded multiple large government defense contracts and is building a new manufacturing plant that has the potential to produce up to 200 UUVs (Unmanned Underwater Vehicles) per year which would translate into hundreds of millions of dollars in revenue per year for Kraken if they continue to use Kraken as their battery supplier.
VitalHub (TSE:VHI)
VitalHub reported 24% revenue growth and 46% cash earnings growth.7 Organic growth continues to be strong, and margins continue to improve. The stock is approaching a $500M market cap which is the minimum threshold for many institutions, which brings more eyes to the company.
We believe VitalHub’s ability to compound isn’t fully understood or respected and future growth isn’t properly reflected in estimates. We saw this in the early days of investing in Constellation Software, where a high margin business, that is run by great capital allocators, doesn’t garner the same attention as businesses in a sexier industry that spend more time on promotion than operation. VitalHub is sitting on a relatively large amount of cash, and we expect more M&A by year-end.
Summary
With the direction of rates now being in our favour, plus attractive valuations and historic dry powder, we believe we’re in the first year of the next 5–6-year cycle for small caps. The stock market may be volatile with upcoming elections and the inevitable headline risk. However, our focus remains on the companies that continue to execute, efficiently deploy capital, and grow earnings.
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
Many of the US bank CEOs speak to this on their earnings conference and mention how the average account as well as the median account have thousands more of cash in them versus pre-pandemic. Important to note that consumers have cash and strong balance sheets. They’re saving versus spending, which is an important distinction.