stock exchange graph

Small-capitalization stocks are known for generating superior returns over the long run. However, stock-picking is particularly important in the small-cap arena, in which companies are at an earlier stage of development and their stocks often are more volatile than established, blue-chip stocks.

Small-caps have underperformed this year, with the BMO small-cap (unweighted) total return index down by 14.3% year-to-date as of Oct. 31 after a sharp correction in October. Although the broader S&P/TSX composite index also suffered a loss in October, its drop for the same 10-month period was 7.3%.

Both Canadian indices are weighted heavily in resources stocks, such as mining and energy, but the imbalance is even more pronounced in the small-cap index. Portfolio managers of small-cap mutual funds who beat their benchmark tend to run portfolios that are more broadly diversified than the resources-heavy benchmark index.

Small-cap stocks’ returns exceeded the broader market’s return rate for the 10 years ended Oct. 31, with the BMO index showing an average annual return of 8.5% – almost double the 4.4% return for the S&P/TSX composite index.

However, small-caps may be more vulnerable as interest rates rise because these firms have a higher proportion of floating-rate debt, on average, than larger companies do.

According to U.S. statistics provided by New York-based Bank of America Merrill Lynch, roughly half the debt owed by companies in the Russell 2000 index of small-cap stocks is floating rate, compared with one-quarter of the debt held by larger companies in the S&P 500 composite index. A moderate level of debt on corporate balance sheets is a key attribute that active portfolio managers seek in the small-cap arena.

Although the tentative U.S./Mexico/Canada Agreement has removed one of the darker clouds hanging over Canada’s economy, continuing trade conflict between the U.S. and China may weigh on global economic growth. Therefore, active small-cap fund portfolio managers seek exceptional companies with the ability to withstand a slowdown.

Steven Kim, associate portfolio manager, Canadian equities, with Calgary-based QV Investors Inc. and a member of the team subadvising on NEI Canadian Small Cap Equity RS, minimizes risk by seeking companies with balance-sheet advantages and a record of cash-flow growth.

“The quality of our companies is significantly better than the average company in the index,” Kim says. “And even within the materials industries, our companies have shown positive performance and have almost no debt.”

The NEI fund is underweighted in resources industries: its 23% resources exposure is less than half of the 47% in the BMO index.

Kim likes stocks that potentially could be held for the long term as the issuing companies grow and develop. The average holding period for the NEI fund is four or five years.

“We aim to buy [shares in] above-average companies that we can own for indefinite periods, that are cheaper than the market and that have strong business franchises and strong balance sheets,” Kim says. “Because of our hold periods, we are laser-focused on businesses that can grow in both good and bad economic times.”

Like other funds in the Northwest & Ethical Investments LP (a.k.a. NEI) stable, this NEI fund employs a sustainable investment approach. The “RS” in its name stands for “responsible screens,” which automatically exclude companies such as producers of tobacco and nuclear power, and others with a poor environmental, social or corporate governance record.

The NEI fund typically holds 25 to 40 names, and currently holds 39. About 90% of the holdings are listed in Canada, with foreign content based in the U.S.

As of Oct. 31, the largest weightings in the NEI fund’s portfolio were financials, at 20%, and energy, at 18%. Major long-term positions include Canadian Western Bank, which has seen its book value increase at an average annual compound rate of 10% for the past 10 years, reflecting the bank’s ability to grow throughout both “up” and “down” cycles. Although the bank is based in the West, it has increasingly diversified into other provinces in recent years.

“The bank has a good record of managing credit risk, and has not sacrificed loan quality in order to grow,” Kim says.

A more recent addition to the NEI fund’s portfolio in the financial services industry is Element Fleet Management Corp., one of North America’s largest truck- and vehicle-leasing companies. This firm is benefiting from a restructured management team that has taken steps to recapitalize the business and reduce costs, Kim says.

“Even within the financial [services] industry,” Kim adds, “the fund has a healthy range of diversity.”

In the energy sector, a key holding in the NEI fund is Parkland Fuel Corp., an independent distributor of fuel products. The company’s businesses include retail gas stations across Canada.

The NEI fund also holds Secure Energy Services Inc., a waste-management and recycling firm serving the energy sector in Western Canada.

“In general, in the resources area, we look for companies on the servicing side,” Kim says, “as they are more diversified than companies focusing on a single area or product.”

Providing further diversification to the NEI fund’s overall portfolio is Aritzia Inc., a women’s fashion retailer that’s growing its in-store sales as well as its online business. In the real estate sector, the portfolio-management team recently purchased Crombie REIT, which has strong assets in grocery- and pharmacy-anchored shopping centres.

Chris Guthrie, president, CEO and chief investment officer of Toronto-based Hillsdale Investment Management Inc., co-manages Hillsdale Canadian Micro Cap Equity Fund along with portfolio manager Alex Etsell. Guthrie says the recent market correction created better valuations for micro-cap stocks and made buying them in quantity easier.

“Micro-caps don’t trade every minute of the day,” Guthrie says. “When there’s not much being offered and people are buying in droves, we stay away.

“Right now, the valuations of small-caps vs large-caps are incredibly attractive,” Guthrie adds. “We don’t have to compete to buy them, so we’re shopping. As stocks get cheaper, the expected return goes up.”

The Hillsdale fund’s portfolio managers seek opportunities within a vast investment universe of about 2,000 eligible Canadian micro-cap stocks, usually holding about 60 names in the portfolio at a time. Typically, individual holdings will have a market cap of $25 million-$300 million.

The Hillsdale fund may hold a stock as its underlying company grows and matures beyond this range if the company remains attractive. However, a limit of 5% for any stock leads to a gradual selling process as the stock price rises.

The selection process for the Hillsdale fund is quantitative, based on criteria such as capital structure, return on invested capital and earnings growth, as well as valuation measures such as free cash-flow yield. Meeting with management teams isn’t part of the research effort, giving the portfolio managers more time to scour the data of a wide range of companies.

The portfolio-management team also examines any available analyst reports and news, and has a scoring system in which factors such as governance and environmental sustainability are graded.

“[Micro-caps] are a broad universe,” Guthrie says, “but we can easily find 60 beautiful companies.”

Among the Hillsdale fund’s longer-term holdings are Savaria Corp., which manufactures equipment for the disabled, including wheelchair lifts, stairlifts, home elevators and accessible vans; and Pollard Banknote Income Fund, which prints tickets for lotteries and charitable gaming organizations.

Other key holdings in the Hillsdale fund include: Wesdome Gold Mines Inc., a mining and exploration company; and People Corp., which provides human resources services, such as individual and group benefits.

The portfolio-management team is careful to maintain diversification by industry, and is finding opportunities in a range of industries and sectors, including commercial services, media, electronic equipment and health-care companies. The Hillsdale fund has some exposure to resources, including 5N Plus Inc., which produces high-purity metals and compounds for electronic applications.

Etsell says the Hillsdale fund’s portfolio is composed of many attractively priced stocks that trade below book value but show annual earnings growth of more than 15%, As a whole, the portfolio trades at only 4.5 times cash flow, which he calls “incredibly cheap.”

Ideally, companies held in the Hillsdale fund mature and enter the radar screen of a bigger crowd of investors who bid the stock price upward. Broad interest on the part of investors can be awakened when a brokerage firm commences analyst coverage or when a company embarks on a corporate finance transaction, makes an acquisition or hires a new senior executive, Etsell says.

The Hillsdale fund’s portfolio managers were early buyers of cannabis stocks, including Canopy Growth Corp. and Aphria Inc. The fund took healthy profits in late 2017 and early this year as market caps soared for cannabis companies – thus, these firms no longer fit the Hillsdale fund’s criteria regarding size.