Canadian small- and mid-cap equity funds have had a tough slog this year, largely a result of investors’ poor sentiment. Still, fund portfolio managers are undeterred and hopeful that selective stock-picking will win out.
“[Poor market performance] is due to the [business] cycle. Last year was very unusual and, by early 2016, cyclical companies were super-depressed,” says Hugo Lavallée, portfolio manager with Toronto-based Fidelity Investments Canada ULC in Montreal, who oversees Fidelity Canadian Opportunities Fund. “Everybody was chasing quality, and you had to own names such as Alimentation Couche-Tard Inc. You couldn’t own any oil stocks. Then, we had a cyclical rebound in cyclical stocks, which was a bit unusual so late in the cycle. But valuations were so depressed.”
What happened in 2017 is typical of late market cycles, Lavallée argues: “Large companies beat small companies; it happens pretty much every cycle. Small companies tend to be more cyclical, have less pricing power and, if inflation is hurting them, they have bigger problems and pass higher costs to customers. What’s happened is that growing companies are more expensive and companies that are struggling to grow are getting cheaper. This is just part of the cycle, more than anything else.”
At some point, there will be an economic slowdown, Lavallée adds, and this looming possibility is a major consideration in building a portfolio. Yet, many stocks are not cheap, he says: “It’s pretty hard to find value. There has been a bifurcation of stocks. Artificial intelligence stocks are expensive and so are cryptocurrency stocks. But the stuff that’s not ‘working’ just gets cheaper and cheaper.”
This situation is reminiscent of 2007-08, he points out: “Late in the cycle, you get this big bifurcation in the market and there is very little volatility, which makes it difficult for active portfolio managers like ourselves. The winners, such as e-commerce firm Shopify Inc., keep on winning. But stocks that may offer good value are more difficult to find. If there’s no earnings momentum [for companies], then people don’t care. So, coming off a cyclical bottom [as happened in 2009] is much easier because [all public companies] are growing. On the other hand, the further you are into the cycle, growing gets tougher. There are more headwinds and you face wage inflation and competitors with more capital. So, companies such as Shopify attract [investment] and it concentrates there.”
Lavallée adds that the market has become one of narratives: “Why would you own a natural gas producer? Instead, you want to own an e-commerce firm because sales are moving to the Internet, or a lithium stock because people are switching to electric vehicles.”
Lavallée, a bottom-up, value-oriented investor, is cautious and holds about 20% of assets under management (AUM) in the Fidelity fund in cash.
“If I have a ton of ideas, my cash gets invested,” he says. “If I don’t have a lot of ideas, I let the cash accumulate. My team doesn’t want to run around with 20% cash, but if we can’t find any ideas, [finding new names] is very hard.”
From a sectoral standpoint, 16% of the Fidelity fund’s AUM is held in energy stocks, 14.3% is in consumer staples, 14.1% is in consumer discretionary and 14% is in energy, with smaller holdings in sectors such as financials.
A top name in the 83-name Fidelity fund is Constellation Software Inc., which provides “mission critical” software for a wide range of clients in more than 100 countries.
“I bought the stock [for the fund] about six years ago, when it was trading at 13 times earnings, and have kept the shares ever since,” says Lavallée. “[The stock price] now is about 23 times earnings, but finding good value [elsewhere] is hard. [Constellation] is a really good company and [the stock] will compound capital over time.”
Constellation’s stock is trading at $734.95. There’s no stated target.
Lavallée also likes Redknee Solutions Inc., once a troubled telecommunications software firm that’s under new management and has been recapitalized. “They’re going to cut costs and will put the company back on the right track,” says Lavallée, adding that a Texas-based private-equity firm has taken a major stake in the company.
Redknee’s shares are trading at $1.10. There’s no stated target.
The malaise in small- and mid-cap stocks can be attributed largely to investors’ negative sentiment regardng energy stocks, says Tyler Hewlett, vice president with Toronto-based BMO Asset Management Inc. (BMOAM) and lead portfolio manager of BMO Canadian Small Cap Equity Fund.
“[Energy is] the second- biggest sector in the S&P/TSX small-cap index and [the sector] is down by almost 25% year-to-date. If you take that out, you’re looking at a mid-single-digit return, which is more in line with the Canadian large-cap market, but still lags the U.S. small-cap and large-cap markets,” says Hewlett, who shares portfolio-management duties with David Taylor, another portfolio manager with BMOAM.
Hewlett argues that throughout North America, the energy sector has been hit hard by concerns about the lingering weak crude oil price: “More specific to Canada are some pipeline and transportation issues, especially for natural gas producers.”
He adds that the infrastructure to move gas to market has not kept pace with growth in regions such as the Montney Formation, which straddles the British Columbia/Alberta border. There also are worries about the impact of negotiations concerning the North American Free Trade Agreement.
“[All this] has created negative sentiment for Canada’s energy stocks,” says Hewlett, adding that many of the risks surrounding energy names have been priced into the market.
Still, Hewlett agrees with Lavallée that Canada’s economy and domestic stock markets are in the late phase of the business cycle.
“[The most recent recession] was many years ago. Right now, all the economic indicators don’t give any signs that a recession is anywhere close, but we don’t have time on our side,” says Hewlett, adding that political uncertainty and populist trends in parts of the world are also worrying. “How late are we in the cycle? We’re not sure. You can never know until much later, but the last recession was almost a decade ago, which historically is quite long. Although central banks have been tightening interest rates [recently], they’re tightening from very low levels.”
From a bottom-up perspective, Hewlett argues that valuations have changed little from a year ago: “Returns are driven by three sources: multiple expansion, earnings growth and dividends. Dividend returns are not a big part of the small-cap market. So, what drives returns is earnings growth. And it’s been strong for the stocks we own.” As well, Hewlett concedes there has been little multiple expansion.
Given that valuations have not become more expensive, being a bit cautious at this late stage of the cycle is wise, Hewlett maintains: “We have to ensure we are invested in companies that are unlikely to disappoint. We have good visibility of earnings and strong management. These stocks’ [prices] should hold better if the cycle were to turn.”
The BMO fund is fully invested and Hewlett, a bottom-up investor, has allocated about 19% of the fund’s AUM to energy stocks. There also is 18% held in industrials, 13% in real estate and 13% in materials, with smaller holdings in sectors such as financials. The 60-name fund’s sectoral weightings are a reflection of Hewlett’s stock picks.
Hewlett favours companies such as Parklawn Corp., which provides funeral services and manages cemeteries and crematoriums in Canada and the U.S. “With baby boomers being the largest cohort in Canada and the U.S., death rates look set to rise for the next 20 years,” says Hewlett, noting that cemetaries are scarce. “And [Parklawn’s industry] is as recessionproof as you can get.”
Although Parklawn has benefited from organic growth of about 5% a year, the fragmented nature of the industry means there’s room for more acquisitions. The stock, acquired for the BMO fund early in 2017, now is trading at $20, or 12 times earnings before interest, taxes, depreciation and amortization. Assuming further growth, Hewlett has a target of about $25 within 12 to 18 months.
Another favourite is Real Matters Inc., a software provider that helps the mortgage lending and insurance industries with mortgage appraisals, title searches and insurance appraisals. The firm’s initial public offering last May introduced the stock at $13, a price that has slipped to about $10. That’s largely because of the downturn in mortgage appraisals in the U.S., which is a result of rising mortgage rates in that country.
“We see this [situation] as a buying opportunity,” says Hewlett, noting that appraisals are cyclical and are likely to trend upward again. “The real story here is increasing U.S. market share. We expect it to go to 20% from 5% in the next few years. That’s what’s going to drive the stock forward.”
Hewlett’s target for Real Matters’ stock is $15 a share within 12 to 18 months.
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