Dear investors,

We have often discussed risk appetite and how it influences investors’ interest in the microcap asset class. During these first six months of 2023, we can say that risk appetite was partially back. While artificial intelligence was the topic on everyone’s mind in recent months, a handful of technology stocks have performed exceptionally well to lead the major US indices to an extraordinary start to the year.

However, there is still no love for Canadian microcaps. Although the fundamental performance of our companies is satisfying, and we believe that they continue to increase their intrinsic value, their stock prices continue to drift lower on small trading volumes. In this letter, we will attempt to dissect the reasons for this dislocation between the companies’ fundamental performance and their market value, in addition to reviewing the five largest positions in the portfolio. We hope to show you that, contrary to what the market might lead you to believe, our companies are doing very well and are, in some cases, extremely undervalued.

Let’s now take a look at some metrics about the fund as at June 30, 2023:

• $8 million in net assets under management.
• 94% was invested and 6% remained in net cash.
• 20 positions. The largest represented 15.2% of the portfolio.

• The top 5 positions represented 62% of the portfolio.
• Fund unit value of $5.18*, for an overall return of – 15.2%** during the semester.

* Series A units (MAJ720)

** Net return after all fees. 

To compare our performance during the first semester (January 1 to June 30, 2023), we use the S&P/TSX Small Cap Index as our benchmark. This index reflects the small cap market performance in Canada. We refer to the LD Micro Index to get an overview of the US market performance. Here is the performance of the two indices during the semester:

 

 

Needless to say, the microcap strategy underperformed the indices significantly for the first half of 2023. We identify a few elements that can explain the underperformance of the fund compared to the indices, but also the underperformance of the microcap asset class compared to large caps:

1. A handful of large-cap companies currently dominate the market. Of the 500 companies that make up the leading US index, the S&P 500, only seven companies are responsible for all the gains (+17%) since the start of the year. This concentration in a handful of big winners is unheard of historically. By dissecting the performance of the indices, we quickly realize that many stocks are still down or are treading water.
2. Negative momentum hurts the microcaps asset class. The very disappointing returns of the past two years are causing investors to gradually shift their capital to other asset classes (especially large caps). By selling their microcaps, sellers put downward pressure on those stocks, driving them down further and creating even more underperformance. This underperformance leads other investors to lose patience and sell, so the cycle continues. Note here how this has nothing to do with the fundamental performance or the companies’ valuations. Instead, it’s all about capital rotation and investor pessimism, two factors likely to swing in the other direction eventually.
3. The low liquidity of our stocks causes them to fluctuate excessively on small trading volumes, thus creating high volatility in returns while the companies’ fundamental performance is stable. We will further discuss liquidity later in this letter.

What will be the catalyst to reverse this cycle of negative momentum for the microcap asset class? We believe the valuation gap between microcaps and large caps will become the catalyst to bring liquidity and interest back to the sector. While large caps are trading at valuations above their historical average, small caps are trading below. A reversion to the mean for both asset classes could cause microcaps to outperform significantly. That said, conviction in the strategy and the positions that make up the portfolio is essential because the market can remain irrational longer than we expect.

Historical Valuation Multiples

Here is a chart of the S&P 500 price-earnings (P/E) ratio over the last 150 years or so:

Source: www.multpl.com/s-p-500-pe-ratio

 

Except for three extreme periods over the past 25 years, the index generally trades in a range of 5 to 25 times earnings, with a historical average of 16 times. Looking at the chart, you will notice that this ratio fluctuates up and down around its average. Although the past is not predictive of the future, we can infer that the index is currently overvalued since it is well above its historical average. To return to its historical average of 16, we would have to see a correction of about 40% (or several years of minimal returns while profit growth reduces the ratio over time).

At the other end of the spectrum, the Russell 2000 index represents the performance of US small caps. The graph below shows that since 1979, this index has been trading at an average price-earnings ratio of 17.7 times (this calculation includes only the profitable companies that make up the index). Currently, the index trades at 12 times earnings, a significant discount from its historical average.

Source: FTSE Russell Research, Russell 2000 – 40+ years of insights 

 

As the markets are cyclical, we can presume there will eventually be a trend reversal and that microcap valuation multiples will increase toward their historical average. Investing in companies that increase their profits every year and seeing an expansion in the multiple that investors are willing to pay for those profits is a solid recipe for generating higher-than-average returns.

Monthly Video Updates

Here are the videos published since the beginning of the year. In these, we elaborate on our research and investment process and share some general insights on the market. Please note that we are taking a break from monthly updates for the summer to rethink how we will communicate relevant information to investors in the best way possible.

You can find the four videos produced in 2023 via the following links:

Monthly Update – January 2023 (7:03)

Monthly Update – February 2023 (8:28)

Monthly Update – March 2023 (7:53)

Monthly Update – April 2023 (7:58)

If you have any questions about the strategy, we will be pleased to chat with you. Feel free to contact us at mathieu.martin@rivemont.ca.

 

Portfolio Review – Top 5 Positions

We regularly mention that our portfolio companies are doing well fundamentally, even though their stock prices have been drifting lower for a long time. In this letter, we decided to share more details about the portfolio to help you understand where we invest your money.  We are hopeful that you will share our conviction in these businesses.

The portfolio is now very concentrated, with over 62% of the capital invested in five companies. The performance of these five companies will largely influence the strategy’s future returns.

Before we get into the details, here is a description of a few terms we will use to discuss valuations below. We use different ratios depending on the type of company and its particularities, as well as the way analysts usually value their peers. Here are the main terms to understand:

Net Income: This is the net profit after all deductions, including certain expenses that do not involve actual cash movements (e.g., depreciation of assets).

EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization): This is the net income to which we add taxes, interest, depreciation, and amortization. For several reasons, these expenses often distort the bottom line of microcap companies. For example, some companies have accumulated losses and do not pay taxes or amortize intangible assets (software, customer lists, trademarks, etc.) they will not need to replace. Therefore, we believe that EBITDA presents a more accurate picture in some instances.

Cash flows: These are the cash inflows and outflows in the company’s bank account. In some cases, these may differ significantly from the net income. For example, a software company that sells annual subscriptions will typically collect payments on day one of the subscriptions but accrue revenue on a prorated basis throughout the following year. This type of business can operate with negative working capital and net loss while generating positive cash flows.

Revenue: This is the total of all sales before any expenses. When a business is not profitable yet, looking at its revenue multiple instead may be helpful. This valuation technique is particularly useful for software companies (especially those with a “Software-as-a-Service” business model) with a large proportion of recurring revenues. According to the SaaS Capital Index, the average valuation for this type of business was 6.5x revenue as of May 31, 2023.

In terms of profits (net income, EBITDA, or cash flows), we consider a multiple of less than 15x attractive, given that the stock market trades on average at 16x profits. At 10x or less, we believe this represents a solid bargain, especially when combined with strong growth.

Without further ado, here is the overview of the five largest positions in the portfolio:

 

1. Microbix Biosystems (TSX: MBX) 

2023 return (6 months): – 6.1%

Revenue growth (2022): + 3%

Profitable: Yes (net income, EBITDA and cash flows)

Valuation: 12.5x 2022 EBITDA / 5.9x our 2024 EBITDA forecast

 

Description 

Microbix creates proprietary biological products for human health, with over 100 skilled employees working out of its headquarters in Mississauga, Ontario. It makes a wide range of critical ingredients and devices for the global diagnostics industry, notably antigens for immunoassays and laboratory quality assessment products (QAPs™). Its antigens drive the antibody tests of approximately 100 diagnostics makers, while QAPs are sold to clinical laboratory accreditation organizations, diagnostics companies, and clinical laboratories.
Recent Fundamental Developments 

Last August, Microbix announced a significant new contract that could generate $5 million in additional revenue in 2023 (on a total revenue base of $19 million in 2022). The client experienced some delays in ordering the products from Microbix, which led to a weaker first half of the year than investors expected. However, these revenues are not lost but only postponed in subsequent quarters.

Last May, Microbix also announced a major partnership to bring back to market a product on which the company has long held the rights. In the short to medium term, Microbix should receive payments based on achieving specific milestones for a total of US$5 million. In the longer term (4-5 years or more), Microbix will be eligible to receive milestone payments based on achieving sales objectives for a total of US$30 million and royalties that may represent tens of millions of US dollars. This product will take several years to bring to market, but we believe it will create tremendous value for shareholders if commercialized successfully.

In the short term, we expect sustained revenue growth in the coming quarters and believe that our investment thesis remains strong over a 3-to-5-year horizon.

 

2. Mediavalet (TSX: MVP) 

2023 return (6 months): + 26.3%

Revenue growth (2022): + 37%

Profitable: No (but has sufficient financial resources to reach profitability)

Valuation: 4.3x 2022 annual recurring revenues / 3.3x our 2023 annual recurring revenues forecast

 

Description 

MediaValet stands at the forefront of the cloud-native digital asset management and creative operations industries. The company sells its software on a recurring subscription basis to mid-market and enterprise clients worldwide. Built exclusively on Microsoft Azure and available across 61 Microsoft data center regions in 140 countries, MediaValet delivers unparalleled enterprise-class security, reliability, redundancy, compliance, and scalability.

 

Recent Fundamental Developments 

We love Mediavalet for its track record of revenue growth over the last several years. Last May, the company released its first quarter results and delivered growth again. Revenue was up 38%, and recurring revenue was up 29% over the previous year.

The business is currently not profitable but has a strong balance sheet and access to a bank line of credit which will, in all likelihood, allow it to achieve positive cash flows without raising additional capital.

Earlier this year, Mediavalet also announced a CEO transition. The new CEO, Rob Chase, was the chairman of the board and a significant shareholder in the company. He has a solid track record with his previous company, Absolute Software, where he contributed to impressive revenue growth for fifteen years. We have known Rob for several years and have the utmost respect for him. We are convinced the company will be in good hands under his governance.

 

3. Ackroo (TSX-V: AKR) 

IMPORTANT: Please note that the Rivemont MicroCap Fund is an insider of Ackroo. The fund holds 17,166,667 shares and 5,416,667 warrants of the company, representing 14.1% of the outstanding shares and 17.8% on a partially diluted basis. 

 

2023 return (6 months): + 8.3%

Revenue growth (2022): + 5%

Profitable: Yes (EBITDA and cash flows)

Valuation: 10x 2022 EBITDA / 7.6x our 2023 EBITDA forecast

 

Description 

Ackroo provides marketing, payment and point-of-sale solutions for merchants of all sizes. Ackroo’s cloud-based marketing platform helps merchants in-store and online process and manage loyalty, gift card and promotional transactions at the point of sale. Ackroo’s payment services provide merchants with low-cost payment processing options through some of the world’s largest payment technology and service providers. Ackroo’s hybrid management and point-of-sale solutions help manage and optimize the general operations for niche industries, including used automotive dealers. All solutions are focused on helping to consolidate, simplify and improve the merchant’s marketing, payments and point-of-sale ecosystem.

 

Recent Fundamental Developments

Ackroo is one of the portfolio’s smallest, most illiquid, and lesser-known companies. The company has a growth strategy that mainly consists of making small acquisitions and integrating them into its ecosystem. Last May, Ackroo reported strong financial results for its first quarter of 2023, with recurring revenue growth of 19% and EBITDA growth of 86%.

Following the recent sale of one of its divisions, Ackroo has some leeway to continue making acquisitions. The company also announced a share buyback to take advantage of its currently depreciated share price.

The CEO has publicly mentioned that his goal is to position the company for an exit to a bigger player within a few years. According to our financial model and the scenarios we think will likely play out, we believe the company could be sold for a significant premium to the current stock price. Of course, nothing is guaranteed, and the future will tell if our analysis was right!

 

4. Kraken Robotics (TSX-V: PNG) 

2023 return (6 months): – 10.7%

Revenue growth (2022): + 60%

Profitable: Yes (EBITDA and cash flows)

Valuation: 20.9x 2022 EBITDA / 6.5x our 2023 EBITDA forecast

 

Description 

Kraken Robotics is a marine technology company providing complex subsea sensors, batteries, and robotic systems. Their high-resolution 3D acoustic imaging solutions and services enable clients to overcome the challenges in our oceans safely, efficiently, and sustainably.  Kraken is headquartered in Newfoundland and has offices in North and South America and Europe.

 

Recent Fundamental Developments 

Kraken is a company we’ve owned since the early days of the microcap strategy. At the time, the company had generated $3.5 million in revenue in its most recent fiscal year (2017). Five years later, the company posted revenues of $41 million in 2022 with an EBITDA of $5.3 million.

Kraken also has a substantial backlog for the coming years, having announced more than $120 million in new contract wins in the last eighteen months.

Earlier this year, the company provided financial guidance for 2023. Projected revenue stands at $66 to $78 million with an EBITDA between $12 and $17 million, representing revenue growth of 76% and EBITDA growth of 275% at the mid-point of the guidance ranges. We have been highly impressed with the execution of the business plan since we started following the company, and we believe that Kraken still has a lot of room to go. At an anticipated valuation of only 6.5x 2023 EBITDA, the stock seems like quite a bargain!

 

5. Imaflex (TSX-V: IFX) 

2023 return (6 months): – 26.8%

Revenue growth (2022): + 4%

Profitable: Yes (net income, EBITDA and cash flows)

Valuation: 4.1x 2022 EBITDA / 5.6x our 2023 EBITDA forecast

 

Description 

Founded in 1994, Imaflex is focused on developing and manufacturing innovative solutions for the flexible packaging space. Concurrently, the Corporation designs and manufactures films for the agriculture industry. The Corporation’s products consist primarily of polyethylene (plastic) film and bags, including metalized plastic film, for the industrial, agricultural, and consumer markets. Headquartered in Montreal, Imaflex has manufacturing facilities in Canada and the United States.

 

Recent Fundamental Developments 

Imaflex is another company we’ve owned since the strategy’s launch and that has executed its business plan very well. Revenue improved from $86 million in 2018 to $112 million in 2022, while net income grew from $3.5 million to $9.1 million during the same period.

The stock experienced a pullback since the start of the year due to recent quarterly results that were weaker than the market expected. The company experienced a few operational issues, including a COVID-19 outbreak at one of its plants and delays in redesigning a product for a significant customer. The company also mentions that several customers pulled orders forward throughout the pandemic to keep enough inventory in stock while supply chain issues raged everywhere. Now that the situation is normalizing, these customers are temporarily working through their excess inventories and ordering less from Imaflex. Imaflex expects to return to growth in the second half of the year.

Although a short-term slowdown is not welcome, we remain confident that the long-term growth outlook is still attractive and that the current valuation provides us with a solid margin of safety. Despite the slowdown, the company remains profitable and has a very healthy balance sheet, so we have no concerns about its financial stability.

 

Private Investments

On the private side, we currently hold two positions representing 7% of the portfolio.

The first company, Good Protein, sells vegan superfood products such as 100% natural protein powders fortified with vitamins and minerals. Its products are sold primarily online directly to the consumer. The company is experiencing tremendous growth and is executing its business plan perfectly. We currently foresee a liquidity event that will allow us to soon monetize this position with an attractive profit.

The second company, Rhetorik, sells data and software on a recurring subscription model to other companies. The financing round in which we participated in 2022 was to allow Rhetorik to invest in research and development to bring an important new product to market. Although there have been some development delays, the product is now on the market, and the company is ready to press the accelerator. Rhetorik has just raised a new round of financing in the form of debt with a major Canadian financial institution and existing investors. This new infusion of capital will enable more investments into sales and marketing to accelerate growth.

Overall, we are satisfied with the progress of our private companies but recognize that there are significant challenges related to private investment compared to the public markets, particularly in terms of monitoring, access to information, and the lack of liquidity of these positions.

Given the correction in the public microcaps market, we believe that public company valuations are currently more attractive than their private counterparts, in addition to being more liquid. For these reasons, we do not foresee initiating other private positions in the short to medium term. We will simply try to maximize our exit strategy in the two positions we already hold. Of course, our opinion could change depending on market conditions.

 

Liquidity of Microcap Stocks

Before concluding this letter, we want to address an important topic regarding microcaps: their liquidity or trading volume.

A stock’s liquidity refers to how rapidly shares can be bought or sold without substantially impacting the stock price. For example, for a highly liquid stock like Microsoft, which trades billions of dollars in volume daily, you could buy or sell $100,000 in the blink of an eye without moving the price more than a fraction of a percentage.

Conversely, most microcap stocks are very illiquid, making it difficult to buy or sell them quickly. Moreover, if someone wanted to do it, it would significantly impact the price (both up and down).

The fact that the trading volume (in $) on the TSX-Venture was down 35% for the first six months of 2023 compared to last year compounds the problem. As the microcaps asset class sees capital outflows and liquidity dwindles, each seller has an even greater impact on prices.

Sometimes, a motivated seller who wants to get rid of a position of tens of thousands of dollars (not millions) can drive a stock down so that it loses several million dollars of market capitalization in a single day. Is the company really worth millions of dollars less overnight? Of course not.

Ultimately, long-term returns will reflect the fundamental performance of our companies and will not result from a few motivated sellers in a market where liquidity is hard to come by. Our “exit strategy” for illiquid positions therefore requires patience. As our businesses successfully execute their business plan, they gradually appear on the radar of analysts and more prominent institutional investors, thus increasing their trading volume and liquidity over time to allow us to take profits.

 

Closing Thoughts

Rest assured that, like you, we are not satisfied with the results of the microcap strategy over the past two years. Philippe Lapointe, our microcap analyst, and I (Mathieu) hold a large portion of our investment portfolio in the Rivemont MicroCap Fund alongside you, and we feel the same frustration.

That said, we remain more convinced than ever that we are in the right place at the right time to generate outperformance over the long term. We are invested in high-quality companies with solid growth prospects, our portfolio is concentrated in a handful of companies in which we have very high conviction, and optimism towards the microcaps sector has never been lower in the last ten years (from our experience).

‘’It’s not always easy to do what’s not popular, but that’s where you make your money. Buy stocks that look bad to less careful investors and hang on until their real value is recognized.’’ – John Neff 

We thank you very much for your trust and patience during these challenging times. As microcaps enthusiasts, we are always happy to talk about the sector, the news from our portfolio companies, or your investment in the Rivemont MicroCap Fund. Do not hesitate to contact us (especially Mathieu) so that we can take some time to discuss together.

We look forward to our next communications!

Rivemont Investments

Portfolio Manager of the Rivemont MicroCap Fund