Surviving The Small-Cap Zombie Apocalypse (+71% YTD 11/30/23)


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As someone that exclusively focuses on small cap value and special situations investing and (selective/tactical trading), conditions have been tricky to very challenging, really since Q4 2021. Frankly, there were long stretches that felt like the 'Small Cap Zombie Apocalypse'. Perhaps, Adam Aron, CEO of AMC Entertainment (AMC), could promote the movie, we just need someone to write the screenplay. In 2022, small caps (IWM), the S&P 500 (SPY), Nasdaq stock (QQQ), and even bonds were taken to the woodshed. Let's face it, 2022 offered a ridiculously high level of difficulty, if you're a long only investor. In 2023, led by a resurgence in the Magnificent Seven, Meta Platforms, Inc. (META), Apple Inc. (AAPL), Alphabet Inc. (GOOGL), Microsoft Corporation (MSFT), Nvidia Corporation (NVDA), and Tesla, Inc. (TSLA), and as of December 1, 2023, the S&P 500 is only 203 points away from minting a new all-time high. On Friday, the Dow Jones Industrial Average (DJI) made a new all-time high.

And then there's the Russell 2000, although resurgent in November 2023, but only up 4.2% year-to-date through November 30, 2023. Measured from its all-time high, of 2,443, through Friday, December 1, 2023, with a close of 1,863, the Russell still sits 581 points or 23.7% away from making a new all-time high. Also, keep in mind, the way indices are constructed, major indices especially, rebalancing of the underperforming names means these names get booted from the indexes, which in turn can result in the understating of conditions for the average stock. Not to mention that most indices are market capitalization weighted and therefore just looking at how the S&P 500, for example, can dramatically skew ground conditions of the average stock.

Therefore, to really crystallize what is going on under the surface, enclosed below is an excellent chart created by Pernas Research, as of November 20, 2023. Incidentally, as we both owned Richardson Electronics, Ltd. (RELL), at a cost basis of sub $11, and Deiya had written on it, here on Seeking Alpha, over the past five or six weeks, I've gotten a chance to meet Deiya and Dean Pernas, via a few Zoom calls. They are both nice guys, passionate about value investing and cerebral.

Pernas Research

Pernas Research

Please take a minute to think about that chart. When it comes to the Russell 2000, from January 1, 2021 - November 20, 2023, 40.5% of stocks are down at least 50%!! That is absolute carnage. And way too many companies have gone onto hit the rocks, as represented above, as 26.1% of stocks are down greater than the 70% figure.

As I've been a full time investor since April 2020, and exclusively focused on small cap value and special situations, I try to track upwards of 500 different stocks, even though my portfolio usually only consists of only owning 10 to 15 names, at one time. As a quick aside, if you're wondering what a special situation stock looks like, please see this article I penned, on Netflix, Inc. (NFLX), on April 21, 2022: As Bill Ackman Liquidated, Netflix Is Now My Largest Sized Position.

Simply put, after the March/April 2020 Covid shock, the Federal Reserve took its Federal Funds rates back down zero. During most of 2020, the 10YR Treasury traded under a 1% yield, as did most of the major global sovereign bond yields. Rates remained way too low throughout most of 2021, and entering 2022, the 10YR was 1.51%. On the one hand, record government stimulus, record unemployment benefits, and massive fiscal/government stimulus led to a major pull forward of consumption. On the other hand, bottle necked/constrained supply chains and a supply constrained work force converged. The by-product of this tectonic force colliding, well was a surge, and what has turned out to be prolonged inflation. As the inflation proved more than 'transitory', the Federal Reserve embarked on the fastest rate hike campaign in history, measured by its pace.

This type of medicine is so potent, especially with a 5.5% Federal Funds rates, that not until recently, given the lag effect of monetary policy, did this high strength/high dose regiment of medicine really start to kick in, to whip inflation. In fact, not that long ago, as in about six weeks ago, perhaps stroked by aggressive shorting of long bonds, the 10YR, albeit briefly, traded up to 5% (October 19, 2023).

To make a long story short, a lot of risky and bad investments were made (second half 2020 - early 2022). The icing on the cake and the poster child of the excess was the SPAC fiasco. The SPAC fiasco was a phenomenon where way too many companies were simply trying to participate in a gold rush, trying to cash in on the then surging demand for 'sizzle', and what turned out to be no 'streak' paper, in the form of stock certificates. We know now that way too many half-baked business models, with questionable management teams, got really good at selling sexy business models. In fact, they got to by-pass the rigors and more detailed/lengthy due diligence associated with going public the old fashion way, via an IPO.

Next, a lot of companies got way out over their skis, and traded at rich multiples to what proved to be peak earnings. Again, this was driven by the surging demand associated with all of that free government money, flowing way too freely. And when people that have the highest propensity to consume get access to an unexpected source of surplus funds, a lot of it got spent. Therefore, the demand signals got blurred. In the aftermath of the party of the century, the hangover was more severe, as it was met with the new and much more dramatic high cost of capital, making it difficult for small companies that were trying to tap the equity and debt markets.

To wrap this section up, as I said, I indirectly track 300 to 500 different companies, and there has been nothing short of carnage, measured by returns, since January 1, 2021, in the small cap patch. The amount of money lost in small caps has been truly breathtaking. As a small cap value investor this has been an exceptionally difficult stretch to navigate. It has required bringing your 'A' game day in and day out. Synthesize so many earnings reports, speaking with management teams, closely following sectors, considering the macro headwinds, and being able to call an audible and pivot, when it was required. In these types of markets, you either adopt and evolve or you get carried out on your shield.

Because of the ridiculously high level of difficulty, I can't imagine too many individual investors have been able to weather this storm that easily. It was really, really easy to get whip sawed and beat up in any number of small caps. Securities selection was paramount during this stretch. Therefore, within your portfolio, you had to have some diversification, needed to really know the companies and sectors, and again, be willing to cash out or take your medicine (losses) when the oceanic forces got too powerful.

As proxy for how strong the oceanic forces have become, in 2023, given the lag effect of that potent Federal Reserve medicine, check out this chart, from S&P Global, showing the big uptick in bankruptcies, through September 30, 2023.

S&P Global Market Intelligence

S&P Global Market Intelligence

The number of companies that I once followed, although thankfully never got involved with, or if I did, quickly took my medicine (losses), that are now down 80% to 90% is staggering. As I said, and I can't emphasize this enough, the performance of the Russell 2000 doesn't come anywhere close to doing justice to how badly the sub $500 million small cap universe has fared during the carnage witnessed from January 1, 2021 - November 30, 2023.

There Is A Silver Lining

On the flip side, there is truly a silver lining. Because so many companies have absolutely gotten taken to the woodshed, in the small cap orchards, believe it or not, there is also a lot of opportunity for discerning and astute small cap investors. Amidst the rubble, there are always some gems to be discovered and purchased. Also, there is a lot of volatility, and that volatility, at least around the margins, can make for good opportunities to capture 10% to 30% tactical trading wins.

The other great aspect is, at least in my experience, is the marketplace for small cap equities is inefficient, bordering on super inefficient, at least at times. Markets are so algo driven that stocks tend to under and over shoot, on both bad and good news. When stocks over shoot, to the downside, these tend be periods marked by enhanced volume and there can be compelling buying opportunities. Again, it goes without saying that you have to know the companies and what you are buying. No question, though, there were plenty of bad businesses that continue on their downward trajectory and shouldn't have been bought. Perhaps, for every twenty to thirty blows up, only one or two was worth buying and owning.

YTD Through November 2023 Biggest Portfolio Winners

  1. TravelCenters of America (TA): Made $32.5K. Owned this name since September 2021. BP p.l.c. (BP) bought them out for $86 per share.
  2. Advanced Emissions Solutions (ADES): Currently, have about a $30K (unrealized gain). I have written on this name extensively.
  3. RCM Technologies, Inc. (RCMT): Made $28.8K. Loaded up at an average stock price in the upper $12s. Exited between $18 and $20 per share.
  4. Kopin Corp. (KOPN): Realized 13K by selling half of the position (still have a large long position, at about a $1.60 cost basis).
  5. Orion Group Holdings (ORN): Made $11.5K. Sold too soon, at $3.75 (capturing 50% gains).

YTD Through November 2023 Biggest Portfolio Losers

  1. Yield10 Bioscience (YTEN): Lost $46K and sold a big position, around early November 2023, around $0.30 per share. Simply put, this management team didn't deliver the big investment and off-take agreement they promised.
  2. iMedia Brands (baby bonds): Bought the bonds, at $0.05 on the dollar. They are currently marked at zero, in my account. The bankruptcy recovery is set to be determined by mid December 2023, with an expected recovery of $0.00 to $0.02 on the dollar. Based on this, my final lose would be $23.5K to $16K.
  3. Mesa Air Group (MESA): I wrote this up, last week. Currently a $15K unrealized loss, with a cost basis of about $1.14.

For people actually looking to see the performance, as seeing is believing, enclosed below is my 2023 (YTD through November 30, 2023) performance.

Second Wind Capital Performance Tracking

Second Wind Capital Performance Tracking

Second Wind Capital Performance Tracking

Second Wind Capital Performance Tracking

Actual Fidelity Performance - Flagship Account (YTD through November 30, 2023)



Actual Fidelity Performance - Smaller Managed Account (YTD through November 30, 2023)



Putting It All Together

Really since Q4 2021, at times, it has felt like the 'Small Cap Zombie Apocalypse'. Per the data from Pernas Research, measured from January 1, 2021-November 20, 2023, 40.5% of companies, in the Russell 2000, were down at least 50%! That is a staggering large percentage of companies, measured over a long period of time, and we're talking about major drawdowns as down 50% is nothing to sneeze at. If you're a small cap investor, even at the margins, even as a piece or certain percentage of your overall equity portfolio capital allocation process, you probably know and understand exactly what I'm referring to. Moreover, as with the SPAC fiasco and as well as for way too many companies, we're talking about permanent to semi-permanent destruction of shareholders' capital. Many of these companies are now bankrupt, flirting with bankruptcy or have conducted highly dilutive secondary offerings, at very low prices, which has marred the expected recovery prospects.

However, despite the very high level of difficulty, amidst all of the drawdowns, this can still be a great environment for fundamental, old school, bottoms up small cap value investors. The reason is the market is inefficient, and super inefficient, at times. Discerning value investors can take advantage of these special situations where the baby gets thrown out with the bathwater.

Despite the heightened volatility, all of the scary headlines, the persistently chronicled macro pieces, as the phrase goes, 'Just Keep Walking', as the clever Johnnie Walker marketing campaign says. Yes, I had the biggest drawdown ever, in August 2023. Yes, both September and October 2023 were really tough. Lo and behold, three months later, in November 2023, the sun came out and the flagship account minted a new all-time high. This is way I love small cap value and why resilience is par for the course.

Good luck to the small cap value bulls, in December 2023!

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.