CANALYST NEWSLETTER: SMALLCAP VALUE INVESTING & NASDAQ:KTEC

In the final newsletter for 2017, we bring you a piece on smallcap value investing and shine a spotlight on Key Technology [KTEC].

Are passive vs. active flows heralding the golden age of smallcap value investing?

In past newsletters, we’ve discussed how industry trends have been pushing attention away from the small/midcap space. Both buyside and sellside readers are familiar with these forces, as the rise of indexing and passive investing causes large-cap concentration on the buyside, and cost pressure forces sellside firms to reduce coverage of small, less “monetizable” names. With MIFID II (the European regulation forcing the separation of research and trading payments) right around the corner, these themes are unlikely to weaken anytime soon.

It's one thing to wax philosophical about these issues, but another thing to see clear examples in the market. This year, I’ve been struck by the number of massive takeout premiums for smallcap names in the market. While relatively low interest rates and easy credit explain some of this activity, the size of some of these bids is pretty staggering, begging the question, how did the public markets get all of these so wrong?

 

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Source: Company reports, Thompson

 

Both the number of bids and the cross-sector nature of the companies involved speaks to something larger going on. Indeed, the number of North American publically traded stocks has fallen from a peak of around 9,000 companies in the late 90s to only around 5,000 today. However exciting it is to see a takeout bid, every time a company gets bought, a Canalyst research associate sadly but stoically deletes the artisanal, hand-crafted financial model from our database, much like a monk ritually erasing a completed sand mandala. On both sides of the Street, losing an investment or coverage company has a similar bittersweet feeling.

So, what does this mean for investment strategy? To me, it speaks that there is incredible and increasing value in looking at names that no one cares about – one of the founding principles behind Canalyst’s massive breadth of coverage. Fair warning, though: there is no free lunch. Looking for these types of stocks is likely to be an extraordinarily painful strategy. On 99.5% of days, these type of names will do nothing. As the FANG bites into your relative performance, or the daily dot.com-esque blockchain-renaming company goes up 40%, you (and potentially your investors!) will constantly wonder whether you’re completely out to lunch. To summarize, while the opportunity seems large and growing, the amount of patience and conviction required would tests even the Buffets and Grahams among us.

So, for all of our clients who plan to tuck into the Canalyst database over the holidays in search of some new investment ideas of 2018, I salute those who are both smart and brave enough to explore the increasingly over-looked smid-cap space. Large rewards (and frustration!) await those who are long on both intellect and conviction. Happy hunting and happy holidays!

In this segment, we are showcasing an underfollowed company within our universe that receives limited sellside coverage. The ~$125 million market cap Key Technology [NASDAQ:KTEC] is this quarter’s feature. We picked it randomly from a basket of names that just crossed our coverage threshold of >$100mm market cap and revenue. As a reminder, Canalyst does not provide buy or sell recommendations, and this profile is simply intended to highlight how quickly you could get up to speed on a new name.

As background, Key Technology designs manufactures and sells process automation systems integrating electro-optical inspection, sorting and process systems. It focuses on helping customers in the food processing and agricultural products industries improve product quality and safety while increasing yield and reducing cost. The Company was founded in 1948 and incorporated on NASDAQ in 1982 as a result of a management buyout. Its focus has been to offer automated processing and inspection equipment that reduces reliance on manual inspection to customers around the world.

The Company is indirectly affected by its clients’ underlying markets due to an increase of orders when demand for its clients’ products increases. It has also benefited from food processing companies facing pressure (from consumers) to improve product quality and safety while maintaining or reducing prices. Earnings and margins have increased in the past two years due to higher net sales and lower operating costs, as a result of higher manufacturing volumes driven by a strong potato market and an increase in orders for its automated sorting and inspection equipment. Within our model, this can be seen in the backlog analysis:

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The markets for automated inspection systems and process systems are highly competitive, with John Bean Technologies Corporation [NYSE:JBT] and Cognex Corporation [NASDAQ:CGNX] being within Key Technology’s peer group in the US. Canalyst models, along with their summary pages, allow you to quickly look through a company’s capitalization, operational data, GAAP and Non-GAAP financials, margins, valuation metrics and more.

Summary pages are available in all Canalyst models and are directly linked to the fully functional financial model itself. With Key Technologies, our model allows you to forecast expected orders and realized revenue % for each one of its segments, allowing you to express your views, and view the results in one concise and summarized spreadsheet as seen below:

KTEC Dec 2017 Newsletter (2).png

 

Wishing you a happy holiday season and all the best in the New Year. Best wishes from the Canalyst Team!

 

As Canalyst continues to grow, our engineering and equity research teams are looking to expand. If you know anyone that is passionate about stocks or technology – or both, we’d love to hear from them! Please send them to the Canalyst careers page to learn about current job openings.

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James Rife

Canalyst, Head of Equities

Prior to founding Canalyst, James had 10 years’ experience in equity research and portfolio management. He started his career in equity research with Fidelity Canada’s investment team, covering sectors including Utilities, Forestry, Technology, and Energy from 2006 to 2010. After Fidelity, he took a role as Portfolio Manager at a Boston-based $1B long/short fund, rounding out his experience across most other sectors in the process.

James holds a Bachelor of Commerce from the University of British Columbia and is a recipient of a Leslie Wong Fellowship from UBC’s Portfolio Management Foundation, and is a CFA Charterholder.


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