Dear investors,

With a sigh of relief, most investors turned the page on 2022. For both equities and bonds, 2022 was a challenging year during which very few sectors were spared.

Of course, our microcap strategy also experienced its share of challenges, given our stocks’ illiquidity and high volatility.

Fortunately, every stock market correction also brings its share of opportunities, and we see them in abundance right now. While Canadian small cap valuations are at their lowest level since the 2008 financial crisis, we consider the current environment excellent for deploying capital with a medium-to-long-term horizon (3 to 5 years or more).

Not only do the growth prospects for our portfolio companies remain excellent over the long term, but we could also benefit from an expansion in valuation multiples over the next several years. This concept is called a “Davis Double Play,” and we will discuss it in more detail later in this letter.

Let’s now take a look at some metrics about the fund as at December 31, 2022:

• $10.8 million in net assets under management.
• 95% was invested and 5% remained in net cash.
• 21 positions. The largest represented 15.2% of the portfolio.
• The top 5 positions represented 52% of the portfolio.
• Fund unit value of $6.10*, for an overall return of – 9.3%** during the quarter and -33.4% during the year.

* Series A units (MAJ720)
** Net return after all fees.

To compare our performance during the fourth quarter (October 1 to December 31, 2022), 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 quarter:
 

 

At the risk of repeating ourselves, we identify the divergence in sector allocations as the main reason for the difference in performance with our Canadian index this year, particularly during the fourth quarter. Companies in the mining sector, which make up a large part of the index, had an excellent performance to end the year. Unfortunately, we have not seen this type of rebound in the two main sectors we focus on, namely technology and healthcare.

The tax-loss selling season also caused an increase in the number of sellers on some of our most illiquid stocks in December, exacerbating their short-term declines. The good news is that we have seen that pressure ease significantly so far in January, and some of our stocks have rebounded nicely. It is still early to call it a trend reversal, but we are nevertheless seeing a slight comeback to life for the microcap sector in these early weeks of 2023.

Let’s continue by looking at the year as a whole:

 

 

Once again, you can see that 2022 was a tough year for our strategy. We expose ourselves to increased volatility by choosing to invest in the smallest, most unknown, and illiquid companies in the North American markets. Volatility can be an advantage or a disadvantage depending on market conditions. It has allowed us to outperform the indices during good times but also led to a more severe correction during a bear market. It is essential to evaluate the strategy on a long-term horizon to judge the performance over a complete economic cycle (a cycle that we have not yet completed).

To provide you with a longer-term perspective of the performance relative to the indices, here are the annualized returns since the fund’s inception in January 2018:

 

 

The fund is still showing a positive return and value-add compared to its benchmarks over five years, although the spread has narrowed following the recent stock market correction. Our goal is certainly to improve on those returns and widen the spread with the indices again in the coming years.

Monthly Video Updates

At the beginning of this year, we started publishing monthly video updates about the microcap strategy. These updates aim to elaborate on our investment strategy and research process and share some general insights on the market.

You can find the three videos produced during the quarter via the following links:
Monthly Update – October 2022 (10:05)
Monthly Update – November 2022 (8:58)
Monthly Update – December 2022 (8:13)

If you have questions about the strategy, we would be pleased to answer them in future video updates. Don’t hesitate to send your questions to mathieu.martin@rivemont.ca.

New Frequency For Investor Letters

Since we now publish monthly video updates, we have decided to decrease the frequency of written letters to two per year (rather than four). We respect the time you spend reading or listening to our updates, and we want to keep the quality and relevance of the content as high as possible. This decision will also allow us to maximize the time we spend analyzing new companies and finding the best investment opportunities.

You should therefore receive two biannual letters from now on, in January and July, in addition to video updates every month.

The Davis Double Play

I (Mathieu) recently started reading an excellent book called The Davis Dynasty. The author tells the story of the Davis family, including that of Shelby Collum Davis, an investor who amassed a colossal fortune of $900 million over a 47-year career. After quitting his job in 1947 to invest full-time, Davis multiplied his starting capital more than 8,000 times before his death in 1994.

During his career, Davis lived through many different types of economic environments: recessions, stock market corrections, long bull markets, periods of inflation, a major crash, periods of interest rate hikes and cuts, etc.

So, how did he beat the market over all these years?

It is not so simple to arrive at a single conclusion, but we can identify a few key elements. First, Davis specialized in a specific industry to become an expert in it (in his case: insurance). He also used leverage well by borrowing on margin at favorable terms to invest.

Then, his investment philosophy was fairly simple: buying high-quality companies with excellent growth prospects, buying them when they were undervalued, and holding them for the long term.

These last few elements gave birth to the “Davis Double Play” concept: buying stocks with higher-than-average growth potential at low valuations. Over the long term, the investor buys at a low earnings multiple, enjoys exceptional earnings growth, and sees the multiple that the market attributes to those earnings expand.

In the long term, stock prices typically converge towards the fundamental performance of the underlying companies (i.e., the earnings growth that is achieved). In the short term, however, fluctuations in stock prices are typically caused by investors’ emotions and opinions. How do investors feel about the fundamental progress of companies, and what multiples are they willing to assign to company earnings?

In a bear market, such as the one we are currently experiencing, investors are increasingly pessimistic, reluctant to take risks, and less inclined to assign high multiples to corporate earnings. Risk aversion is one of the reasons why the market has corrected in the last year or so. Corporate profits have not declined by 20% to 30% as stock prices have. It is simply the valuation multiples that have fallen significantly.

Valuations are now well below their historical average, particularly in the microcap sector. We see this as an excellent opportunity to buy companies growing at an above-average rate, at low valuations, and thus position ourselves for a “Davis Double Play” in the years to come.

Outlook

While it may seem counter-intuitive in the present moment, the outlook for future returns is improving by the day as our businesses keep making fundamental progress, but their stock prices decline. Even though the market hasn’t proven us right in the short term, we remain very optimistic about the companies that make up our portfolio and the strategy’s potential.

Moreover, we are certainly not the only ones to praise the merits of investing in the microcap sector. Let us wrap up with a great quote from Paul Andreola, Co-founder of SmallCap Discoveries, about the current microcap environment:

“This continues to be a market where investors don’t need to chase stocks with big upside while ignoring the big downside. It’s usually the case that to get big returns you must take big risks; you have to pay high prices for high growth. In rare times in the market, you get the opportunity to participate in opportunities with high upside AND lower risk. It’s all a function of price. If you can get a fast grower at a lower price, you’ve actually increased your upside and decreased your risk. You rarely get that opportunity in bull markets, but you can find them more often in bear markets.”

We thank you very much for your trust and patience during these challenging times. Although the Rivemont MicroCap Fund allows withdrawals at the end of each month, the vast majority of investors have elected to stay invested during this past year. Your collective long-term vision creates a strong competitive advantage for the fund. While other fund managers must sell their microcaps at bargain basement prices to pay their investors’ redemptions, our long-term capital base allows us to weather the storm and patiently buy a few bargains along the way. We believe we are positioned exceptionally well for the future. Don’t underestimate your role in this winning formula.

We wish you a Happy New Year filled with health, love, success and prosperity, and we look forward to our next communications!

Rivemont Investments

Portfolio Manager of the Rivemont MicroCap Fund

Units of the Rivemont MicroCap Fund are available under exemptions from the prospectus requirements, pursuant to National Instrument 45-106 Prospectus and Registration Exemptions, and are available only to qualified investors, including portfolio manager clients. This document is not a recommendation nor an investment advice and is presented for informational purposes only.