Navigating Business Cycles
Are we traders or investors?
In life and in the markets, everything comes and goes in cycles. Cycles of pure optimism are followed by cycles of pure pessimism. It is rarely in the middle. It swings from one extreme to the other. The best example is the historical return of the S&P 500, even though it has historically averaged 10%, there are hardly any 10% years. Returns have ranged from -25% in the worst year to +37% in the best year over the last 20 years.
The Nature of Cycles
But it is not just investor sentiment that swings from extreme pessimism to extreme optimism. Most businesses also follow a cyclical pattern. Over half of all companies are tied to commodities in some way: by selling, purchasing, or serving industries that rely on them. Commodities may be disliked by investors, but they are ideal for understanding supply and demand dynamics.
With no product differentiation, it all comes down to supply and demand in those markets. If demand is high, businesses increase their capacity and automatically supply increases at a later point. As supply catches up to or exceeds demand, producers face intensified competition, which generally drives prices lower. These lower prices may initially sustain demand, but as the market becomes oversaturated (oversupply), demand begins to decline. At this point, some producers, particularly those with higher costs or inefficiencies, may struggle to remain profitable and exit the market. And the cycle repeats itself.
The Challenges of Microcaps
When we think of cyclical businesses, we usually think of commodities. But especially in Microcaps, because these are smaller companies that can exploit market inefficiencies more quickly, most companies follow a similar cyclical pattern as well. They take advantage of a supply/demand inefficiency that exists for a couple of quarters. Demand for a new category is high, while supply is still low. Eventually, however, the larger, slower-moving players are able to catch up to this supply/demand imbalance, and the supply side begins to normalize. The loser of this normalization? The Microcap.
These supply/demand imbalances are usually the reason for a small company's high growth. Take the well-known freeze-dried candy manufacturer, for example. The demand for the new category was there, and supply was low for a few quarters (before the big brands entered the space), but eventually they caught up and closed the supply/demand imbalance.
How to survive?
It seems that every small player is therefore doomed to fail. But there are (at least) two proven ways to win the battle against the big companies for more than just a handful of quarters.
The first option is to serve such a small niche that the big brands just don’t care to enter. It just does not make sense. Think of Innovative Food Holdings with their Drop-Ship business for specialty food products. It made and still makes no sense for US Foods to spend a couple of millions, time, and energy to replicate the system for specialty food items. Their time and money is better spent to acquire another Broadline Food Distributor.
The second option to survive is if there are significant barriers to entry. The market may still be big enough that the big brands eventually will get interested in grabbing their fair share of it, but at that point it is easier for them just to acquire the small company than to build a product themselves. If you find a Microcap in one of the two positions, you have a good foundation for long-term returns.
The harsh truth, however, is that 98% of Microcaps will not fall into these categories. They just ride the wave. They have a couple of good quarters in which they benefit from the supply/demand imbalance. After that, the anomaly is gone - and usually they are not able to become big enough within this time period to get acquired. They typically regress to their prior state—effectively returning to no man's land.
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What should investors do?
The most important thing is to understand what you own. Recognize that the business is likely not exceptional. Accept that management might be mediocre at best or even self-serving at worst. This reality applies to most Microcaps.
However, be vigilant for rare exceptions—companies with barriers to entry, capable management, and a sustainable strategy that extends beyond a few strong quarters.
There are many ways to make money in the market, but each requires clarity about the specific game you’re playing. If you’re buying a stock solely because of one strong quarter without understanding the durability of that success, don’t deceive yourself into thinking it’s a long-term investment. It might be, but chances are, it’s more of a trade than an investment—and that’s perfectly fine.
You can also take the different approach. While stocks at cyclical peaks tend to get a lot of attention, you can also look for distressed assets at cyclical lows. It is basically the same game but just with a longer time horizon, instead of buying the breakout quarter which may last one or two quarters, you buy the low, knowing that the industry will eventually turn.
You find an example of a case like this here:
Conclusion
Most Microcaps have a good season, it is okay to own them just for that season, but beware that you are the turkey before Thanksgiving. The real money is made if we as investors make the effort to find out whether this breakout quarter is longer lasting than just a season.
Disclaimer: I own shares of Innovative Food Holdings (IVFH) and may be biased in my opinion. This is not investment advice and meant for entertainment purposes only
“Mastering the Market Cycle” is a very good book that talks about this. Highly recommended…
Sharp take here on the niche or barrier to entry survival strategy.