Canadian small-caps struggled earlier this year, but so did the broader market.
The S&P/TSX small-cap index and S&P/TSX composite index both hit year-to-date lows in late March and have recovered steadily since. As of Nov. 30, the small-cap index’s year-to-date price returns of 4.24% and total returns of 6.70% beat the composite index’s price and total returns of 0.74% and 3.81%, respectively, for the same period.
According to a trends report released in November by New York-based Nasdaq Inc., small-cap players in the U.S. have shown “strong signs of life.” Here in Canada, up-and-coming companies have impressed some fund portfolio managers even as Covid-19 laid on extra pressure.
“Coming into Covid, the initial thing we looked at was how were businesses going to be able to survive?” says Don Walker, portfolio manager with Vancouver-based PenderFund Capital Management Ltd. and manager of the Pender Small/Mid Cap Dividend Fund. The fund only launched on Jan. 31, so performance data isn’t available.
Fortunately for Walker and his colleagues, they found there were very few holdings in the Pender fund “that we didn’t think would survive in an extended shutdown,” he says.
Despite the pandemic, many companies held in the portfolio “are reporting record revenue, earnings and margins,” says Walker, who adds that “management teams have acted and reacted” to Covid-19 in impressive ways.
As of Oct. 31, the Pender fund had $6.6 million in assets under management (AUM) and held between 25 and 30 investments. The majority of AUM was allocated to Canadian equities (83.5%), with most of the remaining balance in cash (12.4%). The top three sectors held by the fund were industrials, information technology (IT) and real estate (32.6%, 12.1% and 11.7%, respectively).
Most of the names in the fund are niche businesses that are less susceptible to widespread or sector-based pressures and trends, Walker says. Rather than allocating assets based on sector-specific analysis, Walker’s strategy is to find strong businesses through detailed research.
“That involves modelling up the companies, talking with management and really understanding the business,” Walker says. “What I particularly like to do is understand [a company’s] cash-flow stream and where [the management team] can invest it and grow it.”
Winnipeg-based Pollard Banknote Ltd. was the Pender fund’s top holding as of Oct. 31, comprising 6.9% of the portfolio. Pollard manufactures, develops and sells lottery tickets, and has been a strong player despite initial concerns over consumer spending during the pandemic, Walker notes.
“[Pollard] reported their third-quarter earnings [on Nov. 9] and it was a record quarter for them,” Walker says. Those earnings revealed a 13% increase in Pollard’s sales and a tripling of net income compared with a year earlier, as well as a record $16.7 million in operating income.
Another fund holding that’s done well is Calgary-based PFB Corp., which saw earnings rise by more than 60% year-to-date as of early November, Walker says. The company, which he says traded at a discount earlier in the pandemic, provides building materials to the residential, industrial and commercial markets.
On the flip side, Edmonton-based K-Bro Linen Inc., another Pender fund holding, has been negatively affected by the pandemic. K-Bro provides services to hospitals and hotels, and the company’s hotel business has suffered during the pandemic. But Walker still sees potential in K-Bro and increased the fund’s holdings of the company.
Walker and his team sold an airline-related holding earlier in the year, given the pressures on the travel industry and the limited ability for management teams in that space to adjust their business models.
Nonetheless, the Pender fund’s turnover for the year has been less than 20%. Walker says any sell decisions are based on three factors: whether a stock is trading above its value, how company management is performing and industry fundamentals.
Walker says he is optimistic about 2021. “For the last number of years, there have been very few tailwinds for small-cap Canada, but valuations now look very attractive,” he says. “Businesses are going to do more with less; they’ve learned how to cut costs, and we have leaner, meaner businesses that are doing quite well.”
Vishal Patel, vice-president and portfolio manager with 1832 Asset Management LP, says there are opportunities to find great small-cap companies in the initial public offering (IPO) market.
“I think 95% of IPOs are garbage, but I do think that in that [other] 5%, we can find that new, emerging Canadian growth company that’s founder-led and doing well,” Patel says.
One recent example of such a company is Montreal-based Nuvei Corp., a top 10 holding in the Dynamic Power Small Cap Fund, which Patel manages. The fund had 38 holdings and $91.5 million in AUM as of Oct. 31. At that time, the fund boasted year-to-date returns of 23.93%, according to Toronto-based Fundata Canada Inc., and three-year annualized returns of 9.29%.
Nuvei is an electronic payment processing company that raised more than $800 million in gross proceeds for its September IPO — the largest-ever technology IPO on the Toronto Stock Exchange.
Patel invested in Nuvei after meeting with company founder Philip Fayer. “We’re essentially now co-investing with [Fayer] and his management team,” Patel says.
“[Nuvei] started out as small-cap and is probably now considered more mid-capish, and I think it has the potential to become a large- and mega-cap company over time,” Patel says.
(S&P Dow Jones Indices defines small-cap businesses as those with market caps of at least $100 million, but not more than $1.5 billion.)
As of Oct. 31, the Dynamic fund’s top three sectors were industrials, IT and materials (22.8%, 20.7% and 17.3%, respectively). The fund invests predominantly in Canadian companies, many of which have performed well during the pandemic.
“The companies that we own have benefited in a Covid world,” Patel says.
The pandemic, Patel notes, has led to many people working and spending more time at home, which has been a boon to Montreal-based Richelieu Hardware Ltd., another of the Dynamic fund’s holdings.
“This whole idea of work from home has led to people staying home and renovating their houses. Whether it’s lumber or building products, Richelieu is a distributor of hardware products,” Patel says. “Essentially, anything housing-related has done well.”
Patel’s research process involves forging a strong connection with companies’ management teams. He dissects companies’ earnings, organic growth and dividends, and examines how companies stack up against their competitors.
“If you look at the top 10 holdings, we have very minimal change,” Patel says. “If you look at turnover, that’s less than 25%. We try to own real businesses.”
In the year to come — and as a general rule — Patel suggests investors shouldn’t have a negative outlook for Canadian small-caps.
“I like the U.S. market, and there are huge large-cap opportunities there,” Patel says. “But in Canada, there’s tremendous opportunity in small-caps.”