TMX POV - 2024: The Year of Small Cap Comeback? - Spotlight on TSX Venture Exchange

Heading into 2024, there's a growing sense of optimism in the financial sector, especially regarding small-to-mid cap stocks.

Interest rate hikes, a tool used to mitigate recession risks, have significantly influenced small-cap stocks, particularly in the aftermath of the 2021 capital markets surge. This shift is not only due to the Federal Reserve's strategy of maintaining higher rates but also because of a change in valuation perspectives. With rising interest rates, the discounted cash flows of these companies are viewed differently i.e. when interest rates rise, the cost of borrowing increases which translates to a higher cost of capital and therefore a higher discount rate, resulting in much lower valuations. This change in financial assessment has made these stocks less attractive to investors who are now more critical of balance sheets that don't showcase strong potential for growth.

Moreover, the market looks to have observed a pivotal shift in investor sentiment, transitioning from favoring growth to prioritizing value. Investors who might prefer larger companies with more stable cash flows and dividends, may re-allocate capital away from small-to-mid cap companies impacting their valuations. This shift places small caps in a challenging situation, as they must adapt to investor interests to secure capital. This adaptation is essential because, traditionally, small caps have been celebrated for their potential for robust earnings growth. However, under current market conditions, their ability to deliver this growth is questioned.

Richard de Chazal, a macro analyst at William Blair, aptly compares small caps to speedboats in the equity world. They are agile but highly sensitive to market changes, unlike larger, more stable 'supertanker' stocks¹. This analogy highlights the current vulnerability of small caps in a rapidly changing economic environment, where investor priorities and the broader economic framework have shifted significantly since 2021.

Key to this sensitivity is small caps' reliance on capital markets for growth funding, often necessitating more frequent borrowing. This makes them first in line for less favorable borrowing conditions and more susceptible to interest rate fluctuations and economic cycles than larger-cap stocks.

At the recent Annual Economic Outlook hosted by the Executives' Club of Chicago, John W. Rogers, Jr., Chairman and Co-CEO of Ariel Investments, shared his insights, suggesting that 2024 might be a landmark year for smaller and value stocks. These stocks had taken a back seat throughout most of 2023, overshadowed by the market rally led by the "Magnificent 7," which now command a market cap more than triple that of the Russell 2000.

Rogers drew parallels between the current market and the internet bubble era, noting, "We think it's an extraordinary time for smaller and value stocks. It's reminiscent of the internet bubble period. When that bubble burst, it was a great period for small and value stocks as the larger market started to falter."

He also highlighted the potential in small-cap companies beyond the Magnificent 7². According to Rogers, these stocks are often "hidden gems," overlooked and undervalued in the current market landscape. Contrasting with Warren Buffet's general advice to invest in the S&P 500^Ⓡ, Rogers emphasized the current opportunity in stocks that are "misunderstood, neglected, not well-followed, [and] not well-researched," describing them as "extraordinarily cheap" and ripe with investment potential.

Historical patterns indicate a potential shift in stock market dynamics, where small-cap stocks may take the lead, particularly in the event of an economic downturn. According to an article by Barrons which analyzed the trends from the last 11 recessions reveals an interesting pattern: small-cap stocks have historically outperformed large-cap stocks by approximately 16% in the year following the onset of a recession. Take, for instance, the era surrounding the dot-com bubble burst. Between 1995 and 2000, the S&P 500 consistently outperformed the Russell 2000, averaging an eight-percentage-point lead annually. However, the tables turned in the period from 2001 to 2004. During these years, the S&P 500 experienced a decline of about 2%, whereas the Russell 2000's value segment witnessed a remarkable surge of 80%.³

A research report dated January 16, 2024 by National Bank of Canada Financial Markets (NBCFM), anticipates a period of "catch-up" for small-to-mid cap stocks within their scope of analysis.⁴ The report observed that numerous small-to-mid cap companies have implemented strategies to improve their capital allocation, similar to their larger counterparts. However, these strategic moves have not yet been fully reflected in the valuations of many such companies. This discrepancy may present a unique opportunity in the market for these undervalued stocks.

TSX Venture Exchange: A Haven for Small-to-Medium Cap Companies

Amid these challenges, TSX Venture Exchange (TSXV), the junior market to Toronto Stock Exchange (TSX), stands out as a unique and tailored solution for small- and mid-cap companies. Increasingly, U.S. companies are looking to TSXV as a financing option. In the past five years, 55 U.S. companies listed on TSXV accessing public venture capital for their growth funding. And in the past two years, even under tough market conditions, notable U.S. companies such as Midwest Energy Emissions, Full Circle Lithium, The Fresh Factory, and Yerbae Brands listed on TSXV.. Leveraging TSXV as an alternative to private capital options, in the past five years, TSXV U.S. companies raised CDN$7.8B through 490 financings, representing an average of CDN$15.9M, which is truly venture capital.

You can hear from the CEOs about their capital raising options and why they chose TSXV through the TMX Presents podcast.

TMX Presents: The Podcast with Highlighted U.S. Companies

• Yerbae Brands Corp (TSXV:YERB.U) - Podcast Episode 030
• Full Circle Lithium Corp (TSXV:FCLI) - Podcast Episode 033
• Midwest Energy Emissions Corp (TSXV:MEEC) - Podcast Episode 031

Graduates from TSXV to TSX further exemplify TSXV's efficacy as an incubator marketplace. Several U.S. companies graduated in the last five years, including Real Brokerage, Quipt Home Medical Corp, and Hamilton Thorne.

TSXV offers U.S. companies an alternative avenue to U.S. public capital and traditional private venture capital, with TSXV issuers raising, typically between $2mm-$25mm. This path, scarcely available in the United States, is bolstered by an ecosystem of retail and institutional investors, investment bankers, and analysts specifically attuned to small cap stocks. The cost savings, coupled with more significant employee incentive mechanisms, make TSXV an attractive option for the right U.S. company. Successful companies on TSXV have the opportunity to graduate to TSX and potentially cross-list on a major U.S. exchange.

In conclusion, 2024 has the potential to be a landmark year for small-cap stocks. TSXV emerges as a beacon of opportunity in this landscape, offering a unique pathway for growth and success to U.S. companies. For companies considering going public, the choice of market is crucial. TSXV not only presents a viable option but also a unique value proposition in the dynamic world of small-to-mid cap stocks. As we venture further into 2024, let's watch closely as this exciting chapter in the financial markets unfolds, potentially reshaping the future of micro caps.

For more information on TSX and TSXV and to connect with your regional representative, visit us.tsx.com.

¹ "Markets Brief: Is It Finally Time to Buy Small-Cap Stocks?", Morningstar, Inc., 
https://www.morningstar.com/markets/markets-brief-is-it-finally-time-buy-small-cap-stocks

² "Ariel Investments says ‘Magnificent 7' stocks could underperform while neglected names rebound next year", CNBC
https://www.cnbc.com/2023/12/12/top-investors-say-magnificent-7-stocks-could-underperform-while-neglected-names-rebound-next-year.html

³ "Small-Cap Stocks Can Shine in a Recession", Barrons.
https://www.barrons.com/articles/small-cap-stocks-buy-recession-invest-b3377cae

⁴ "Technology Year Ahead 2024, Still More Upside", NBCFM Thematic Research.
https://nbfm.ca/research

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