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Small-cap stocks are ‘trying to find a footing,’ strategist says

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North Star Investment Management Corp CIO Eric Kuby joins Yahoo Finance Live to discuss the action surrounding small-cap companies wading through supply chain issues and interest rate hike environments, the Fed, and stock selection.

Video Transcript

- Let's talk about the week in the markets with Eric Kuby the CEO of North Star Management Corporation. Eric, it's good to see you. I am going with Rachelle's suggestion that we wear sweats at work, sweat pants down below. I appreciate the suit and tie, though. That is a nice effort, Eric.

ERIC KUBY: Yeah, I just I wish I knew about that ahead of time. I'm back in the office. Now I feel unproductive. I should go back to my house and put sweatpants back on.

- OK, man, next time, you're allowed to wear your sweats. But let's talk about the week in the markets and how we wrapped it up today. What's your broad takeaway?

ERIC KUBY: Well, we focused really on the small cap stocks. And they've been quite volatile but really not going much of anywhere recently. So again, down one day, even hour by hour they seem to be swinging around. But it does seem like you're seeing some stabilization. I think the bad news has largely been priced in. And I think the market in general, and small caps in particular, are trying to find a footing here to move forward.

RACHELLE AKUFFO: And you've been actually meeting with about 25 small cap companies over the last two weeks. As part of that, you've heard about this persistence in terms of supply chain-related delays being beyond what they expected with their Q2 recovery estimates. How were you advising that they navigate this period?

ERIC KUBY: Well, again, I think the thing about the supply chain challenges are that they're not going to go on forever. And I think the big surprise, as you indicated, was that, most of these companies, when we did talk to them just three or four months ago, they were really forecasting the supply chain issues to have really alleviated by now or into the early spring. And now they just don't see that happening.

They don't want to give predictions anymore because they keep thinking it's going to get fixed. But they've gotten used to having these delays. Their customers have got used to having products being delayed, being shipped in. And it's just been a consistent business headwind that's still there. But again, is not going to be there, certainly not next year and hopefully later this year will clear up.

JARED BLIKRE: And Eric, I do have to say, I appreciate the suit, kind of match here. But I want to keep talking about the small caps and interest rates, because we have the Fed looking and sounding pretty aggressive. They only raised 25 basis points the last meeting. It seems like everybody's talking about 50 as a sure thing for May.

I'm just wondering, when we have rising interest rates, a lot of these smaller companies have huge debt loads they have to service. And a lot of them are simply zombies. They're not going to be able to pay their interest unless they can attract new capital. That's going to be very difficult in a rising interest rate environment. Just wondering how you're filtering and you're selecting some of the more quality stocks.

ERIC KUBY: Yeah, thanks. That's a great question, because people forget. They look at the Russell 2000 as an index. And they see that half the companies don't make any money. And a lot of them have terrible balance sheets. But there's thousands of companies. So what you do is you search for those companies that have great balance sheets and that do make money.

And we're able to find some terrific candidates, a lot of them with big cash balances, again, very, very profitable. So this is where we think that stock selection becomes super important and why we think active management, particularly in the small cap arena, makes a lot of sense, because you filter out the heavily levered companies and the ones that are losing money and end up with the better ones.

- Eric, clearly the markets had priced in the last action from the Fed. Have these small caps, the 25 you spoken with, factored in five or six additional hikes the rest of the year?

ERIC KUBY: Yeah, so that was really interesting. So we had a little checklist of questions we asked every company. And one of them had to do with the rising interest rate environment. And we didn't come across a single company that was concerned about these short-term rates getting ratcheted up. Most of them that have longer-term debt, it's locked in at very favorable rates.

So companies have had a long time to get their balance sheets, their debt structures, their capital structures in order. So again, I think that most of them have done a terrific job doing that. And yeah, everybody expects short-term rates to get up to 2% or higher in a relatively reasonable time frame.

And that is factored into their plans. But again, I think of the 25 companies we talked to, none of them expressed concern over those interest rates rises.

RACHELLE AKUFFO: And I want to shift gears now and talk about the Russia-Ukraine fallout and potentially what we might see in China, depending on how you view their relationship with Russia or perhaps some of these outbreaks that are also perhaps squeezing the supply chain as well. What are you advising some of these companies who source some of their products from these regions?

ERIC KUBY: So, again, another that was one of our checklist questions about China. But that's been a checklist question for us going back a number of years, because if you recall, there was a lot of talk about trade war with China. If we looked at the headlines from years ago, that was the big headline.

All of the companies that manufacture, source from China, they have been uniformly spending that time trying to move production to Vietnam or Mexico or South America, other places where they can do their manufacture to the extent that they can. So that process is multi-years, in the works already, and continuing on.

Now, there are some things that just need to be made from China. And again, those companies are going to continue to source those materials from China. But this process of moving the supply chain as quickly as possible away from China has been in the works for quite a while.

JARED BLIKRE: All right. We have to leave it there. But Eric Kuby, really appreciate you stopping by, North Star Investment Management Corporation CIO.