Market Call: Jordan Zinberg's outlook on Canadian Small and Mid-Cap Stocks

Key Concepts

• Small and Mid-Cap Stocks: Companies with a market capitalization smaller than large-cap companies, often exhibiting higher growth potential but also higher risk.
• Resource Sector: Industries focused on the extraction and processing of natural resources, such as mining and energy.
• Non-Resource Growth Stocks: Companies in sectors like technology, consumer discretionary, or healthcare that are not directly tied to commodity prices.
• Valuation: The process of determining the current worth of an asset or company.
• Multiples: Financial ratios used to compare the value of a company to its earnings, revenue, or book value (e.g., Price-to-Earnings ratio, EV/EBITDA).
• Capital Allocation: The process by which a company decides how to spend its money on various investments and projects.
• M&A (Mergers and Acquisitions): The consolidation of companies or assets through various types of financial transactions.
• Vertical Market Software: Software designed for a specific industry or niche market.
• Carve-outs: The divestiture of a business unit or subsidiary from a larger corporation.
• Digital Health: The use of digital technologies to deliver healthcare services and information.
• Ad Tech (Advertising Technology): Technologies used to automate the buying, selling, and delivery of digital advertising.
• Return on Equity (ROE): A measure of a company's profitability that calculates how much profit a company generates with the money shareholders have invested.
• EV/EBITDA (Enterprise Value to Earnings Before Interest, Taxes, Depreciation, and Amortization): A valuation metric used to compare companies within the same industry.
• Net Asset Value (NAV): The net value of an asset, calculated by subtracting liabilities from assets.
• CMHC (Canada Mortgage and Housing Corporation): A Crown corporation that provides mortgage loan insurance and other housing-related services.
• Frac Sand: Sand used in hydraulic fracturing (fracking) to extract oil and natural gas.
• LNG Canada: A liquefied natural gas (LNG) export facility under construction in British Columbia.
• Short Sellers: Investors who sell borrowed securities with the expectation that the price will fall, allowing them to buy them back at a lower price.
• Dollar-Cost Averaging: An investment strategy where an investor invests a fixed amount of money into an investment at regular intervals, regardless of the price.

Canadian Small and Mid-Cap Stock Market Overview

Jordan Zinberg, President and CEO of Bedford Park Capital, discusses the performance of Canadian small and mid-cap stocks.

Current Market Trends and Drivers

• Year-to-Date Performance: Small and mid-cap stocks have largely been left behind for most of the year, but a change has been observed in the last month.
• Canada vs. US: Canada has outperformed the US in both large and small-cap segments.
• Narrow Breadth in Small Caps: While small caps have performed well, the rally has been very narrowly focused, with approximately 80% of trading volumes coming from mining stocks.
• Resource Sector Dominance: The TSX and TSX Venture indices have seen a significant portion of their gains attributed to mining stocks. This has rewarded mining investors but also driven capital away from non-resource names.
• Impact on Non-Resource Growth Stocks: Many non-resource small-cap growth stocks have been left behind in the current rally.

Small Cap Tech Performance

• Canadian Small Cap Tech: Has not performed well this year, with only a few standouts.
• Investor Perception: Non-Canadian investors do not typically invest in Canada for tech companies; they are drawn to resource companies.
• Success Factors for Canadian Tech: Canadian small-cap tech companies need to perform exceptionally well to stand out and often end up being acquired by larger peers.

Outlook for Year-End and Early 2026

• Mining Rally Continuation: Zinberg does not predict an end to the mining rally, noting that such rallies typically last for one to two years and occur every five to seven or eight years.
• Capital Flow Reversal: Capital is expected to flow back into non-resource growth stocks as the mining rally eventually ends.
• Attractive Valuations: Fundamental buyers are beginning to look at the low multiples of profitable growth stocks.
• Defensive Move to Small/Mid Caps: The shift back to small and mid-caps is not necessarily defensive but rather an opportunistic move due to less institutional capital and more inefficient pricing.
• Opportunity in Small Cap Growth: The setup for investors in small-cap growth is considered excellent due to less attention and more price dislocations.

Company-Specific Analysis and Stock Picks

Enterprise Group (EGR)

• Business Description: Traditionally an energy services company providing equipment for oil and gas sites. They have transitioned into the power business by renting turbines for natural gas power generation, which offers high margins.
• Management Strategy: Intends to transform into a pure power company, moving away from energy services.
• Catalyst: Successful transition, potentially following the acquisition of Flex Energy Canada, could lead to a rerating of the stock to a higher multiple, similar to power or infrastructure companies. A name change is also possible.
• Analyst Opinion: Positive on the transition and potential rerating.

Kraken Robotics (PNG)

• Business Description: Manufactures underwater drones and other products for naval applications.
• Positives: Excellent products, good growth, and operating in a hot defense sector with increased global defense spending.
• Negatives: The business is "lumpy" due to dealing with large government contracts and defense budgets, which can cause delays.
• Valuation Concern: The stock is trading at a huge multiple, and it will take time for the company to backfill this valuation.
• Competition: Competitors exist, and contract wins serve as a validator for technology.
• Analyst Opinion: Cautious on valuation despite a great company and products.

Happy Belly Food Group (HBF)

• Business Description: A collection of fast-food and quick-service restaurants. They acquire smaller brands and use their expertise in real estate, operations, marketing, and branding to grow them, primarily through franchising.
• Comparison: Similar model to MTY Food Group, a larger player in the Canadian market.
• CEO: Shawn Black is highly praised for his passion and execution.
• Growth: Growing rapidly in Canada and has signed US agreements.
• Valuation Concern: The valuation has gotten a bit ahead of itself, but the CEO's performance is expected to backfill this.
• Competition: Competes with MTY Food Group and all major fast-food chains.
• Analyst Opinion: Impressed with the CEO and business model but finds the current valuation a bit high.

NTG Clarity Networks (NTC)

• Business Description: A geographically focused IT services company operating in Saudi Arabia and neighboring countries, similar to CGI Group in Canada.
• Growth and Profitability: Has grown profitably, but recent profitability has suffered due to investments in the business and hiring staff in advance of contracts, some of which have been delayed.
• Management: Investing in larger contracts, high insider ownership.
• Takeout Potential: Likely to be acquired by a player seeking a presence in Saudi Arabia, which is investing heavily in its tech industry as part of its diversification away from oil.
• Analyst Opinion: Bullish on the long-term prospects, believes it's a good place to be, and would buy at current low multiples. Still owns the stock.

Lumen Group (LMN)

• Business Description: Spun out of Constellation Software, focusing on vertical market software for the media and communications sector. They tend to do larger "carve-out" deals from big companies.
• Stock Performance: Lagged due to Constellation Software issues and AI concerns. A lack of recent acquisition announcements has also impacted the stock, as M&A is crucial for Lumen.
• Valuation: The ecosystem (Constellation and spin-offs) trades around 20 times earnings, down from 30 times earnings a few months ago.
• Analyst Opinion: Sees this as an outstanding chance to step in at current levels ($25-30 range) for a quality company.

ARCO (ARX)

• Business Description: A mining services company, one of the largest drilling companies. Closest peer is Major Drilling.
• Market Cycle: Drillers have not participated as much as expected in the current mining cycle.
• Performance: Stock has improved but utilization is still a bit low.
• Strategy: Diversifying away from high-risk areas and junior mining companies, though some reliance on junior miners remains.
• Valuation: The stock is cheap and has been for a long time.
• Takeout Potential: Could be acquired at some point.
• Analyst Opinion: Surprised the stock hasn't run up more given the mining cycle, but it's a well-run company and cheap.

Well Health Technologies (WHT)

• Business Description: Started as a digital healthcare company, but has acquired physical locations (e.g., CRH Medical).
• Founder: Hamid, the founder, has a strong track record.
• Investor Concerns: Integration of acquisitions and the perceived lack of fit between acquired companies.
• Current Stage: Still in the early innings of seeing what the company will become.
• Analyst Opinion: Believes it's a well-run business in a good space (digital health). If they can integrate and show a clear strategy, the stock should pick up. Has not owned due to valuation concerns in the past.

Past Picks Review (January 2024)

• GoEasy (GSY):
  • Performance: Down 24% in return, 21% total return drop.
  • Current Situation: CEO departure due to illness, ongoing CFO transition, and a short report from a US investor.
  • Analyst View: Despite volatility and being misunderstood (non-prime lending), the company has a strong track record. Investors need to accept volatility. The stock has historically seen significant drops followed by strong rebounds.
  • Outlook: Believes the stock will rebound to $200 or more, but timing is uncertain. Fast-growing company with over 20% return on capital, trading at six times earnings.
• Main Street Equity (MEQ):
  • Performance: Down 9% in return and total return.
  • Business: Owns rental apartments, focusing on mid-market housing in Western Canada (50-100 unit buildings, ~$1,200/month rent).
  • Market Dynamics: Demand driven by immigration and students, but supply is constrained due to high construction costs.
  • Analyst View: The story hasn't changed, and this is the lowest valuation seen in years, trading at a 25% discount to NAV. The company has a strong track record and is on track to reach 20,000 doors. CEO Bob Dylan owns half the company.
  • Key Advantage: Operates in provinces without rent control and benefits from cheap CMHC financing (around 3% interest).
• Source Energy Services (SHLE):
  • Performance: Down 16% in return and total return.
  • Business: One of the largest frac sand players in Canada (50% market share). Transports sand from Wisconsin to Western Canada and provides integrated logistics.
  • Customer Base: Long-term contracts with large-cap energy players. Sand is identified as a strategic asset.
  • Recent Quarter: Was a little weak.
  • Outlook: Demand for sand is increasing due to the LNG Canada project and regular demand.
  • Valuation: Trading at just over two times EBITDA, considered very cheap.
  • Takeout Potential: Likely to be bought out by a larger energy services company, a US competitor, or private equity.
  • Analyst Opinion: A takeout in the US space (US Silica) at a higher valuation suggests significant upside potential for Source Energy.

Q&A with Callers and Emailers

• Kraken Robotics (PNG): (Discussed earlier) Cautious on valuation.
• Happy Belly Food Group (HBF): (Discussed earlier) Valuation a bit high, but impressed with CEO.
• NTG Clarity Networks (NTC): (Discussed earlier) Bullish, still owns, would buy more.
• Lumen Group (LMN): (Discussed earlier) Good entry point at current levels.
• ARCO (ARX): (Discussed earlier) Cheap, surprised it hasn't run more.
• Well Health Technologies (WHT): (Discussed earlier) Well-run, good space, but early innings.
• GoEasy (GSY): (Discussed earlier) Still has faith, expects rebound.
• Main Street Equity (MEQ): (Discussed earlier) Low valuation, low sleep loss stock.
• Source Energy Services (SHLE): (Discussed earlier) Cheap, potential takeout.
• Kits & Care (KITS):
  • Business: Online eyeglass company with one store in Vancouver and a new store opening in Toronto.
  • Concept: Excellent concept, allowing online purchase of glasses with prescription upload and digital try-on tools.
  • Founder: Good pedigree, previously sold Coastal Contacts.
  • Competition: Warby Parker in the US.
  • Challenges: Getting people to buy glasses online is a departure from traditional shopping.
  • Performance: Stock has been volatile due to company investments impacting profitability.
  • Takeout Potential: Likely to be sold one day.
  • Analyst Opinion: Great process, product, well-run, growing business, good Canadian success story. Fast delivery times.
• Bird Construction (BDT):
  • Business: Construction company that will benefit from infrastructure projects.
  • Backlog: Massive backlog.
  • Performance: Stock did well, then missed a quarter and sold off. Has been trading sideways.
  • Outlook: Expects next year to be better with resumed growth, margin expansion, and large projects coming online.
  • Management: Well-run company with good contract administration that helps preserve margins.
  • Analyst Opinion: Hold on to the stock, better days ahead.
• McCoy Global (MCB):
  • Business: Oil and gas technology company focused on making wellbores safer. Offers products and services that reduce labor and improve drilling safety.
  • Revenue Model: Drives recurring revenue through ongoing monitoring fees.
  • Financials: Well-run with a clean balance sheet and no debt.
  • New Product: TRES system is expected to win more contracts.
  • Analyst Opinion: A winner, has held up well despite lower rig counts and spending. Long-term prospects are good.
• Quip (QIPP):
  • Business: Home medical healthcare company, popular during COVID.
  • Current Situation: Not as much spotlight post-COVID.
  • Takeout Interest: Has had a non-binding bid, indicating interest in the company.
  • Analyst Opinion: Believes the company will likely be taken out.
  • Investment Strategy: Generally does not average down. Prefers to add capital to names as they move higher, allocating capital to working investments. Advises selling if a better use for capital exists, otherwise, consider holding for a potential buyout.
• Calian Group (CGY):
  • Business: Operates in Ottawa with divisions in IT, advanced technologies, and health.
  • Performance: Stock has been doing well, hitting a new 52-week high.
  • Activist Involvement: Seems to be helping the stock.
  • Analyst Opinion: A good, solid name, well-run, with a dividend. Would own in a more defensive fund. Continue to hold.

New Top Picks

Zoom Technologies (ZOMD)

• Business: Ad tech business helping blue-chip clients (Amazon, NBA, Shein) unify ad sources and strategize ad buying.
• Market Position: Operates outside the "walled gardens" of Google and Facebook.
• Growth: Revenue grew over 70% last year, and over 20% this year. Profits are growing very fast.
• Customer Concentration: Top five customers represent about 70% of the business, but there's potential for international expansion with existing clients.
• Analyst Opinion: Excellent numbers and high insider ownership. First analysts initiated coverage recently. The reason it's not a larger position is the cyclical nature of ad tech and less robust disclosures.

Propel Holdings (PRL)

• Business: One of the best growth profiles in Canada.
• Recent Announcement: Moving forward with becoming its own bank, which is expected to reduce costs and allow for new product launches.
• Valuation: Trading at about six times forward earnings, considered a distressed multiple for a company growing at 30-40% annually with a 30% return on equity.
• Comparison: Contrasted with Laurentian's acquisition at 12 times earnings despite declining earnings and a 9-10% ROE.
• Analyst Opinion: Huge dislocation in the stock, makes no sense. Pounds the table on Propel, expecting a significant rebound. Calls it a "no-brainer" at $25.

Constellation Software (CSU)

• Business: Owns hundreds of software companies, focusing on vertical market software.
• Concerns: AI threat and surprise CEO resignation (Mark Leonard) for health reasons.
• AI Impact: Too early to definitively answer the AI question. The company sees it as both an opportunity and a threat. They are already using AI and can leverage best practices across their portfolio.
• Valuation: Trading at 19-20 times earnings, a multiple not seen in about ten years.
• Analyst Opinion: One of the best companies in Canada for compounding capital at a high rate. Sees this as a phenomenal entry point for investors who don't own it.
• New CEO: Mark Miller, who has been with the company for 30 years and was involved in its first acquisition.

Market Update

• TSX: Down 104 points to 30,997.
• S&P 500: Down 7 points.
• Nasdaq: Up 104 points, almost 0.5%.