businessman searching with binoculars

While small-capitalization stocks have a reputation for outperforming their large-cap counterparts over the long term, this David vs. Goliath scenario hasn’t been holding up lately — at least, when measured by traditional stock market indexes.

This year, the Toronto stock market has been characterized by a preference for defensive stocks as investors seek to insulate their portfolios from the possibility of an economic slowdown.

“At the moment, there is a fairly defined preference in the broader market for more defensive stocks, such as consumer staples and utilities,” says Bruce Campbell, founder and portfolio manager of StoneCastle Investment Management Inc. in Kelowna, B.C., and manager of Purpose Canadian Equity Growth Fund. “In this environment, small- and mid-caps tend not to get stock price performance. Many investors are trying to jump ahead of any possible recession and protect their portfolios.”

As a result, small-caps have lagged this year, with the S&P/TSX small cap index up by 4.8% for the 10 months ended Oct. 31, significantly lagging the S&P/TSX composite index’s juicier gain of 15.1%.

Furthermore, for the 10-year period ended Oct. 31, 2019, the S&P/TSX small cap index had a scant average annual compounded return of 0.78%, while the S&P/TSX composite index had an average annual compounded gain of 4.2% over the same period.

Both Canadian indexes are heavily tilted toward resources, which have generally been stuck on the sidelines of market action.

Small-cap mutual funds’ portfolio managers who have achieved superior returns tend to diverge widely from the index, concentrating on small companies with big growth potential. In particular, portfolio managers have steered away from cyclical metals, minerals and energy companies, the stock prices of which have dragged as these companies struggle to contend with soggy commodity prices and transportation challenges.

Survival is more challenging for small companies than it is for larger, more mature firms. Access to capital generally is more difficult for fledging companies with short track records, and brands and business relationships often are less entrenched.

Smaller companies also tend to be less diversified, as they may have sprouted from the seed of a single business idea and haven’t branched into other areas. Small-caps frequently are launched and nurtured by entrepreneurs who have specific talents, but who may lack skills in key management areas.

The upside of small-caps is that they offer investors the opportunity to find a diamond in the rough, and to take a position in a promising young company with huge growth ahead of it. The percentage growth from a small base is potentially much larger than for established blue-chips.

Campbell applies top-down strategies as well as individual stock analysis. The Purpose fund also will hold a large cash position when he sees signs of trouble. Recently, the Purpose fund’s cash position was about 18% of assets under management (AUM), but it has been as high as 50%.

“We can be neutral, or on the offence or defence,” Campbell says. “Currently, we are cautious. If the market drops en masse, small- to mid-cap companies tend to fall more. We like to have cash available to buy at reduced prices and get accelerated returns on subsequent recoveries.”

Campbell seeks companies with exceptional growth potential, superior earnings, and solid and improving fundamentals. This approach tends to lead him to the small- to mid-cap arena, but he may also hold large-caps.

For example, last summer the Purpose fund acquired positions in Bank of Nova Scotia and Canadian Imperial Bank of Commerce as the yield curve on market interest rates began to widen. Short-term rates drop faster than long-term rates, so banks benefit because they borrow short-term and lend long-term, Campbell says.

Campbell focuses on companies trading at reasonable valuations relative to their growth prospects rather than looking for companies that are simply cheap. When stocks become recognized, he continues to hold if earnings keep pace with the rising valuation, but trims his position if valuations get rich. Because small-caps are volatile, he limits risk by keeping the weighting in any company to 2.5%-4% of AUM. The fund typically holds 25 to 40 companies.

The Purpose fund’s most dominant sector is health care, at about 25% of AUM. The top holding is Kentucky-based Protech Home Medical Corp., which provides in-home monitoring equipment and medical supplies to patients. Another top holding is Louisiana-based Viemed Healthcare Inc., which was spun off by Protech and is involved in a variety of activities, including respiratory disease management and sleep apnea treatment.

The Purpose fund also holds Reliq Health Technologies Inc., a Hamilton, Ont.-based developer of remote patient monitoring and telemedicine solutions to link patients with health-care professionals.

Campbell also has been active in cannabis stocks, as his firm runs StoneCastle Cannabis Growth Fund.

Among the cannabis holdings in the Purpose Fund are Kelowna-based Valens GroWorks Corp. and Barrie, Ont.-based MediPharm Labs Corp., both of which specialize in methods for extracting cannabinoids for use in next-level products.

“The [cannabis] industry is moving beyond dried flower and oil to beverages and edibles,” Campbell says. However, “not all marijuana companies will be successful and not all management teams are wise with their capital. It comes down to who can execute well. [Furthermore], we are at the start of a worldwide legalization wave. Eventually, the big pharmaceutical companies and consumer-products firms will move in.”

marc lecavalier, vice president, small-cap equities, with Montreal-based Fiera Capital Corp. and lead portfolio manager of NBI Quebec Growth Fund, also is conscious of investors’ reduced appetite for risk.

He has been taking advantage of price dips to upgrade the quality of the fund’s portfolio. Although a recession doesn’t appear imminent, Lecavalier says, he’s focusing on companies that can weather an economic downturn.

“We take a bottom-up approach and don’t make macro calls. But, at this point, we’re trying to be a little more conservative and are paying more attention to stock liquidity,” says Lecavalier.

The NBI fund has a 10-year average annual compounded return of 14.2% as of Oct. 31, making it a top performer in Morningstar Canada’s Canadian small-/mid-cap category during various periods. The fund has a below-average Morningstar risk rating and lower volatility than the category overall.

The NBI fund is unusual in that it concentrates on companies that are either based in Quebec or conduct a meaningful portion of their business there. Although the fund’s holdings all have a link to Quebec, many do business on a national or global scale. The bias is toward small-cap names, but the fund may hold a portion of large-caps if Lecavalier sees value; the fund’s large-cap allocation is 11% of AUM.

One of the keys to the NBI fund’s success, Lecavalier says, is identifying winners at an early stage of their development and holding the stocks as companies mature and grow. When small-caps graduate to become larger-caps and are more widely recognized, their stocks often trade at higher valuation ratios.

Lecavalier’s style is to invest gradually in companies, augmenting the stake if he likes the way management responds to challenges and growth opportunities.

Examples of multi-year holdings include Stella Jones Inc., a producer of utility poles and railway ties, and MTY Food Group Inc., a franchisor and operator of casual restaurants under such brands as Cultures, Jugo Juice, Mr. Sub and South St. Burger. (Both companies are based in St-Laurent, Que.)

Another top holding is Longueuil, Que.-based Héroux-Devtek Inc., a firm specializing in the manufacturing, testing and repair of landing gear, actuation systems and components for the aerospace market. With international operations, the firm benefits from healthy defence sector spending globally and growing airline travel. “Héroux-Devtek is an example of a stock we bought early, and as the growth story unfolded, we increased our holding,” Lecavalier says.

Another key holding is Montreal-based WSP Global Inc., an engineering consulting firm that benefits from robust infrastructure spending around the globe. Lecavalier says WSP has a high degree of recession resistance. “We don’t see a slowdown in big infrastructure projects, as many governments continue to spend,” he says. “The company continues to grow organically and through acquisitions.”

Companies that show disappointing results or fading prospects are sold. Within the past year, the troubled Montreal-based engineering giant SNC-Lavalin Group Inc. was discarded from the NBI fund.