Sector Watch: Small-cap stocks trading at a discount

As well, investors who used to favour smaller companies now are older, more conservative and risk-averse, Barr adds: “Aging boomers have a big part to play. They drive where the market is going.”

Although some investors are creeping back into the small-cap market, says Barr, “it’s not a situation like in 2006. People are still generally cautious. But in my neck of the woods, the best-of-breed companies are being recognized. Companies that have predictable revenue and a long history of profitability and growth are attracting investors. Things that are more speculative, or may have had issues in the past, that’s where you can find very good value.”

Barr, in adding that he prefers to buy companies that are trading at a 50% discount and benefit from strong management teams and high returns on invested capital, says he’s been able to identify stocks on a selective basis. “But it’s more challenging than it was three years ago,” he says. “These days, you have to dig deeper to find better values.”

A value investor, Barr is avoiding resources stocks, which are too volatile for his liking, and maintaining about 25% of the Pender fund’s assets under management (AUM) in cash.

“Small-cap share prices are correlated with news and events – such as when a company loses a customer and markets overreact,” Barr says. “When that happens, I like to buy stocks.”

From a sectoral standpoint, 39% of the Pender fund’s AUM is in information technology (IT), which reflects Barr’s background in venture capital. There’s also 12.6% in health care, 9.5% in energy, 4.1% in industrials and smaller holdings in sectors such as financials.

Running a portfolio with 38 names, Barr likes firms such as QHR Technologies Inc., which provides electronic medical records. “The adoption of electronic records [in Canada] is at about 40% today,” says Barr, “but everywhere else in the industrialized world, it’s about 95%. We’re way behind, but we will get to 95% in the next three to five years.”

QHR, a market leader, is expected to double its revenue in about five years. QHR stock is trading at about 90¢ a share, or about one time revenue. Barr believes fair value is about $1.40 a share.

Small-caps are trading at a 28% discount to large-caps, based on price/book value measures, says Teresa Lee, managing director with Toronto-based Sionna Investment Managers Inc. and manager of Sionna Canadian Small Cap Equity Fund. “Normally, there is a 20% discount. So, small-caps are even cheaper than large-caps,” she says, adding that the benchmark BMO small-cap index is down by about 1.4% year-to-date in contrast to the S&P/TSX composite index, which is up by about 7.5%.

The disparity is largely attributable to the weak materials sector, which accounts for about 25% of the benchmark and is down by about 30% for the past year.

“It’s partly due to China,” says Lee. “And it’s also because a lot of companies in the [materials] sector are not real businesses and don’t have a long-term track record of generating earnings. When you have weakness in commodities prices, you see stock prices really suffer. But a few years ago, [materials stocks] were in favour when people believed in significant Chinese growth. Those were the high-beta names to play.”

Conversely, Lee says, sectors such as IT, health care and consumer discretionary have done well: “Many have achieved double-digit returns in the past year.”

Still, Lee says it’s unfair to use a broad-brush approach because some resources companies are doing well. “A lot of energy service companies can do well, for instance, because they generate earnings and cash flow at trough commodities prices. You know they will do really well when things recover. But a lot of marginal businesses will just hang on,” she says.

Lee argues that valuations are key to the small-cap sector, regardless of where the economy is going. “A lot of people view the economy as driving markets. For us, it comes down to valuations and what’s being priced into stocks,” says Lee. “Our focus is: how will a company perform in a downturn? If it’s a low-cost producer and not a cyclical business, it should be fine, regardless of the environment.”

Financial services account for about 24% of the Sionna fund’s AUM, followed by energy (20%), materials (13%) and industrials (13%), with smaller weightings in sectors such as consumer discretionary. There also is about 7.5% cash. A bottom-up stock picker, Lee is running a 49-name portfolio.

One top holding in the Sionna fund is Pulse Seismic Inc., which offers an extensive library of data that many oil and gas exploration firms have come to rely upon. Says Lee: “[Its] library of data is an essential part of their customers’ business. And Pulse has pricing power because the service comes at a relatively small cost.”

Pulse has operating margins in excess of 70%, she adds. The share price is about $3.70, or about eight times free cash flow.

Ralph Lindenblatt, senior vice president with Calgary-based Bissett Investment Management, a division of Toronto-based Franklin Templeton Investments Corp. and lead portfolio manager of Franklin Bissett Small Cap Fund, argues that small-caps are materially cheaper than large-caps mainly because of the higher economic sensitivity of smaller companies.

“Energy and materials have much more volatile earnings streams,” says Lindenblatt. “Given the cyclicality of earnings, that’s the main reason for the significant discount with large-caps.” (Small-caps as a group are trading at around 1.3 times book value vs 1.6 times for large-caps.)

“Global growth will impact energy and materials,” adds Lindenblatt, who shares portfolio-management duties with Richard Fortin, vice president of Bissett. “When growth is robust, we see strength in commodities, such as base metals and agricultural. To the extent that growth has slowed recently, that has weighed on the small-cap market.”

Other factors to consider are the liquidity discount, which pushes small-cap valuations down; greater challenges in accessing capital; and lower dividend yields. “There has been a flight to dividends,” Lindenblatt says. “They are much more limited in the small-cap space.”

But it’s a tale of two markets, he adds, echoing his peers. “If you exclude materials and energy, things don’t look that bad,” he says, pointing out that IT is up by about 45% year-to-date, and consumer discretionary stocks are up by 29% year-to-date.

Given the share price appreciation in some sectors, Lindenblatt says, small-caps are not so cheap. “But you need to adjust for the cyclicality of the small-cap earnings,” he adds.”With the heavy weighting of the materials sector, I’d say we are closer to trough levels of earnings rather than peak. If you make this adjustment, the price/earnings ratio is not so bad.”

Lindenblatt, a “growth at a reasonable price” investor, looks for companies with strong balance sheets, financial flexibility and management that makes good use of capital. About 24% of the Franklin Bissett Small Cap fund’s AUM is in consumer discretionary stocks, 22% is in energy, 20% is in industrials and 14% is in financials, with smaller weightings in sectors such as materials.

One top holding in the fund is Horizon North Logistics Inc., a leading provider of camp-management services to the Canadian oil and gas industry for facilities in remote areas of the country. “[Horizon North] is well-positioned,” says Lindenblatt, “to benefit from the continual sizable capital outlays in the oilsands.”

Horizon North’s stock is trading at about $8.40 a share, about 15 times earnings. The stock also pays a 3% dividend. There is no stated target.

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