Canadian small- and mid-cap stocks have been hurt this year, largely due to the European sovereign-debt crisis, which has reduced the appetite for riskier investments. And although the concerns about Europe may take some time to subside, some fund portfolio managers argue that small-cap valuations are attractive; others are more cautious.
One of those in the latter camp is Jason Gibbs, vice president with Toronto-based Goodman & Co. Investment Counsel Ltd. and co-manager of Dynamic Small Business Fund. “In a ‘risk on’ environment,” he says, “people are much more willing to pile into small-caps. But in a ‘risk off’ environment, inves-tors tend to move into cash and large-caps that have good liquidity. If you start to get some selling pressure, small-caps can fall off very quickly.”
Indeed, Gibbs notes, this situation is evident in the benchmark BMO Nesbitt Burns small-cap index, which is down by about 15% year-to-date. (In contrast, the broader S&P/TSX composite index has fallen by about 8%.)
Restoring confidence in global markets means heading off a potential European banking meltdown that would be fed by sovereign-debt failures. “Banks will not lend, and will need to sell assets or raise capital,” Gibbs says. “This could lead to a liquidity crunch, which is not good for anyone.”
In Gibbs’ view, Europe is a wealthy region that has the financial means, with the aid of the European Central Bank, to extricate itself from its mess: “This is what the U.S. did. That’s when the Federal Reserve Board agreed to do everything it could to put the U.S. banks back in better shape.” So far, though, the ECB has not responded similarly. “That’s what markets are looking for.”
In the meantime, Canadian small-caps have seen their price/earnings multiples drop. Earlier this year, small-caps were trading a slight premium to Canadian large-caps, Gibbs says. Now, they are trading at about a 10% discount.
Gibbs, a bottom-up portfolio manager, shares duties with Goodman vice president Oscar Belaiche. Significantly, about 20% of the 70-name Dynamic fund’s assets under management is in cash, down from a high of 33% in June. “There are some attractive opportunities,” says Gibbs. “But you’re not finding the [ones] where companies are trading below their cash.”
Six per cent of the fund’s AUM is in gold producers, vs 33% in the index. Says Gibbs: “We took some of the risk off the table at the start of the year.”
Still, he likes energy producers and energy infrastructure firms, which together account for about 26% of the fund (vs 25% in the index). A top name is Innergex Re-newable Energy Inc. Formerly an income trust, the firm owns and operates wind-power and hydroelectric plants in Canada and the U.S. “It has a very stable cash flow [and] one of the longest power purchase agreements in the business, and it is growing to meet demand,” says Gibbs, noting that its contracts are often 20 years in duration. “You have a nice, steady cash-flow stream combined with good growth.” The stock is trading at around $9.90 a share and yields 5.9%. Gibbs has no stated target.
Another favourite is Morneau Shepell Inc., a human resources outsourcing firm that also has a steady income stream from its consulting services. “Over the next while,” says Gibbs, “dividends will represent a good part of a stock’s returns. If you can find a company with above-average dividends that are sustainable, you will do quite well.” The stock is trading at $9.80 a share and yields 7.9%.
Jennifer Law, vice president with Toronto-based CIBC Global Asset Management Inc. and portfolio manager of
CIBC Canadian Small-Cap Fund, also acknowledges that the appetite for risk has dropped since the second quarter of 2011. “Markets are pricing in another recession,” she says, “and some form of hard landing in developing countries. The real estate bubble and inflation issues in China and India are concerns. Can [these countries’ economies] continue to grow? This is critical, because these countries have been driving demand for a lot of the basic materials.”
Problems in Europe, the U.S. debt ceiling debate and a potential U.S. recession have only exacerbated worries in the market, Law adds: “Commodities stocks in general got hurt, but juniors got decimated in this market. People were running away from risk. The market has been so volatile. The feeling is that people want to be defensive and want liquidity. That’s why they are gravitating to larger-cap names. Small-caps are out of favour.”
Still, small-cap valuations are now more attractive. “We began the year with multiples trading in line with large-caps,” Law says. “But we’ve fallen further than large-caps. Now, the index is trading at a 25% discount on a price/sales basis vs large-caps, and 10% discount on a price/earnings basis.”
Law, a “growth at reasonable price” investor, had been deploying some of the CIBC fund’s cash during the sell-off, adding to some existing positions and making modifications to the portfolio. In general, though, she has also become more cautious. “We have taken down some of our energy exposure and added names with yield,” says Law, noting she has traded out of some gold producers and bought a gold bullion exchange-traded fund. “We’re trying to balance the risk profile of the portfolio. The challenge is that resources names account for more than 50% of the index. How do you reduce volatility if half of your world is commodities-driven?”
The CIBC fund is overweighted in energy but underweighted in materials. Still, the two sectors combined represent about 48% of the fund’s AUM.
One of the top picks in the 74-name CIBC fund is Canadian Energy Services & Technology Corp. This Calgary-based firm provides specialized lubricants (known as “drilling mud”) for the oil and gas industry. “When you have the right type of mud,” says Law, “it’s faster and allows companies to save a lot of money.” Canadian Energy S&T, which has seen its market share grow to 30% from 5% in 2006, has a second line of business that delivers production fluids. The stock is trading at $12.35 a share, with a 4.4% yield. Law believes the share price could be in the high teens within two years.
Law also likes Killam Properties Inc., a Halifax-based firm that is one of Canada’s largest residential landlords. “It has grown a lot, mainly through acquisitions,” she says. “What’s great about this company is that it has a good yield, and apartment buildings are very low-risk.” Killam stock is trading at $10.60 a share, with a 5.4% dividend yield. Law’s target is about $12 within two years.
Markets are discounting another financial crisis, says Martin Ferguson, director with Calgary-based Mawer Investment Management Ltd. and portfolio manager of Mawer New Canada Fund, which is closed to new investors. “They are discounting the high probability of a worst-case scenario,” says Ferguson. “If that doesn’t pan out, you will have some upside, which will be limited by slower economic growth.”
So, what do small-caps offer in this environment? In Ferguson’s view, the potential is very attractive. “We’re seeing 8%-11% internal rates of return,” says Ferguson, who will estimate a company’s internal rate of return and rely on discounted cash-flow models to determine a stock’s fair value. “And that’s a good sign. Alternatively, if you put your money into a 10-year Government of Canada bond, you may get around 2%; you might get 1% in a money market fund. So, we believe there is quite a margin of safety in equities prices.”
Ferguson also notes that mergers and acquisitions are increasing, fuelled by low interest rates and strong corporate balance sheets. This environment, he points out, augers well for small-caps that are potential takeover candidates.
Still, Ferguson cautions, markets could be volatile for some time, and there could be further downside if there is a freeze in the credit markets because of the crisis in Europe: “That’s a low probability. But it does exist.”
Ferguson is a bottom-up investor who likes companies with strong management and business models, and minimal risk. A top name in the 55-name Mawer fund is Constellation Software Inc., which provides so-called “mission critical” software to about 20,000 organizations, from municipal transit authorities to golf and country clubs. A long-term holding, Constellation’s shares have slipped to $66 from $78 this past summer, mainly because the planned sale of the firm did not pan out. “But it is still good value,” says Ferguson, noting that the firm has a 20% internal rate of return and the stock has a 3.1% dividend yield. There is no stated target.
Another favourite is Paladin Labs Inc. The Montreal-based firm is a niche player in pharmaceuticals, distributing endocrinological and urological drugs. “It can buy drugs that other companies are not interested in,” says Ferguson, adding that Paladin has about 70 drugs in its catalogue. “Its gross margins are around 70%. It has no debt, and throws off a lot of cash.” Paladin stock trades at $38 per share. IE