Small cap stocks fought an uphill battle in Q3. Investors around the world reduced risk in response to a cacophony of geopolitical and economic factors. The back-of-the-envelope move was to shift funds into more secure investments. In ancient times, say ten or twenty years ago, that would have entailed selling shares in vulnerable companies and buying into safer ones. Nowadays, with the trend towards indexing, there's less discrimination involved. Investors make a short-cut decision that big cap stocks are safe and small cap stocks aren't. Or they move in and out of entire industries with sector specific ETF's ("Electronically Traded Funds"). That's a convenient strategy for massive portfolios. But the tail can wag the dog for individual stocks. Good companies get thrown out with the bad. And that creates opportunities.
That ETF gravitational pull dragged down our performance. Walrus Partners' S-2 fund endured a -2.70% decline in the September quarter. That was less than the Russell 2000's setback of -7.36%. But our showing was below that of the major indexes, like the S&P 500, which benefited from the changing flow of funds (+1.13%). We only had two stocks (UQM Technologies and Napco Security) that reported lower than expected financial results. The fund's mediocre performance mainly was due to diminished investor confidence. That probably stemmed from slow growth in Europe, questions about China, conflict in Ukraine and Iraq, and the Ebola crisis. Even the U.S. looked peakid despite the fact it continues to outperform the rest of the world. Real personal income still is lower than it was before the 2008 collapse. And the unemployment rate would be 10.4% today if the work force participation rate was the same as it was back then.
Strong business performance didn't necessarily translate into stock price gains. Our largest holding, Profire Energy, posted spectacular June period results. Our estimates for the oilfield equipment manufacturer were pretty aggressive but the company topped them, nonetheless. Despite that the share price fell -8%. It's now trading at 20x earnings despite the fact it is capable of growing 50% compounded or more over the next several years. Industry factors explain the short term pressure. Slow economic growth worldwide combined with expanding U.S. oil production caused crude prices to slide over the summer. Saudi Arabia ordinarily would have scaled back output to buttress the market. But the Saudis are relying on America to stabilize the Middle East and contain its arch enemy Iran. The decline in price could make it easier for us to extract a nuclear deal with the Persians. It also may put the squeeze on Russia, helping us in Ukraine. Profire is continuing to race along with a unique product aimed at a huge market with little direct competition. When the big picture improves substantial appreciation is possible.
Highpower International bucked the trend. Those shares advanced +66% as the company found new and large markets for its lithium batteries. Highpower already is well established in the consumer electronics area. The company specializes in plastic lithium power supplies for cell phones, laptop computers, and a wide range of similar devices. This year it penetrated the electric vehicle and solar back-up segments. New capacity is coming on line. Margins are poised to widen as those economies of scale are realized. Sevcon is another likely beneficiary of the electronic vehicle ramp-up underway in China. Up to now China has been a copy-cat economy. Air pollution has become so severe, though, that it has taken the lead in electric vehicles. Sevcon is a well-established provider of computer controls for battery-powered vehicles, both on- and off-road. A recent venture with a huge Chinese partner could multiply the company's size over the next few years.
Several stocks are poised to take off in the short term. Cyanotech is a producer of natural astaxanthin, a nutrional supplement that reduces sunburn, macular degeneration, and joint pain. It also boosts athletic performance and may have anti-aging characteristics. Demand is booming. The company already owns 50% of the specialty retail market. Now it's expanding distribution with larger retailers like Vitamin Shoppe, Costco, and Whole Foods. A costly legal battle is coming to an end. That expense has eaten up most of Cyanotech's earnings over the past two years. As those costs reverse and the business continues to expand reported income could soar.
Northern Technologies is virtually unknown even among small cap aficionados. Earnings are growing faster than sales in the core business. And total income is being amplified by the company's entry into the oil and gas market. Northern has a unique way of preventing steel from rusting while it's being shipped or sitting in inventory. At the end of the manufacturing process steel typically is painted or processed in some way, which prevents rusting. But while it's sitting around steel can rust in a hurry. Northern provides a simple solution to the problem. It also operates around the world, providing multinational customers with an end-to-end solution. Now the company is protecting offshore oil platforms and onshore storage tanks. Earnings growth is gaining further momentum as a result.
Health Insurance Innovations is the only stock we added in the quarter. The company is a leading provider of Short-Term Medical health insurance policies. Those offer the same coverage as major medical plans, but they fall outside the new Obamacare rules. Short-Term plans are for a fixed period, usually 6-12 months. They don't automatically renew. And they only are sold to people who pass the physical exam. Because the plans are sold exclusively to healthy people, they cost 40%-50% less than comparable Obamacare plans. The company recently expanded into the general health insurance market, as well, with the launch of a website that displays information on virtually every plan that's available coast to coast. Individuals do the research themselves on the site. Then, after they've narrowed down their choices, they contact one of Health Insurance Innovations' call centers. The company helps them select the best one. It earns a commission when the transaction is complete. Deal flow has risen dramatically. That trend could accelerate further when the Obamacare open enrollment period begins in November. The closing rate is higher, too, because the call centers are dealing with informed customers. In the past a lot of phone calls were from people inquiring from scratch.
The outlook for the stock market as a whole remains decent. Reported earnings probably will moderate in Q3, and perhaps for a few quarters after that, in response to the strengthening U.S. Dollar. Foreign income will translate at a lower rate. But real business performance will be largely unaffected. Most U.S. companies retain their foreign earnings overseas. Returning those funds makes them subject to steep taxes. If the money never moves currency translation becomes an academic exercise. Foreign results also might be diminished by slow going in Europe. Up to now Germany has blocked a full scale stimulus effort. Germany itself is sliding into a period of negative growth, though. The money is likely to begin flowing before long, to prevent the mother ship from sinking if nothing else. That could benefit the entire region.
QE-4 is winding down in the United States. Many investors worry that the lack of bond buying will lead to a crash. What they forget is that the U.S. money supply has grown 7% annually no matter what the QE situation has been. Any extra money has been sucked out of circulation and stored as excess bank reserves by the Federal Reserve. Overall liquidity won't be meaningfully affected by the program's end. Interest rates are likely to stay low, perhaps for the entire duration of President Obama's second term in office.
Special Situation growth stocks could enjoy strong gains once conditions stabilize. Our 2015 earnings estimates (see the following table) suggest an average year-over-year improvement of +94%. Our portfolio's average PE multiple for 2015 is 17x. Sentiment on Wall Street has turned negative. Once everything converges a sturdy uptrend could develop.
Walter Ramsley
Executive Editor
( Click on Table to Enlarge )
